MBA 2 Accounting For Decision Making Jan 2014

ACCOUNTING FOR
DECISION-MAKING
STUDY GUIDE

PROGRAMME : MBA Final Year

CREDIT POINTS : 20 points

NOTIONAL LEARNING: 200 hours over 1 semester

TUTOR SUPPORT : accdm@mancosa.co.za

Copyright 2014
MANAGEMENT COLLEGE OF SOUTHERN AFRICA
All rights reserved; no part of this book may be reproduced in any form or by any means, including
photocopying machines, without the written permission of the publisher

REF: ACCDM 2014

Accounting for Decision-Making

MANCOSA - MBA FINAL YEAR 1
MODULE CONTENTS: ACCOUNTING FOR DECISION-MAKING

TOPIC
NUMBER

TOPIC

PAGE(S)

Readings

3

1

Accounting information and managerial decisions

5

2

Financial statements and accounting concepts

17

3

Accounting for and presentation of assets, liabilities and owners equity

40

4

Income statement and cash flows

61

5

Financial Analysis

82

6

Cost-volume-profit (CVP) relationships

125

7

Cost analysis for planning, control and decision-making

153

8

Transfer pricing for decentralised enterprises

183

9

Corporate governance

193





READINGS

Prescribed
Marshall D.H., Mcmanus W.W. and Viele D.F. (2011) Accounting: What the numbers mean,
9
th
Edition, McGraw-Hill: New York

Recommended
The following books are highly recommended for further reading.
The books that are recommended for each topic are indicated at the start of the topic.

Atrill P and Mc Laney E (2002) Management Accounting for Non-specialists, Third edition,
Pearson Education Limited: Essex
Berry A. and Jarvis R. (2006) Accounting in a business context, Fourth edition, Thomson
Learning: London (Chapter 3)
Davies T. and Pain B. (2002) Business Accounting and Finance, First Edition, McGraw-Hill:
UK
Drury C. (2005) Management Accounting for Business, Third edition, Thomson Learning:
London
Gowthorpe C. (2005) Business Accounting and Finance for non-specialists, Second edition,
Thomson Learning: London
Hand L., Isaaks C. and Sanderson P (2005) Introduction to Accounting for Non-Specialists,
First edition, Thomson Learning: London
Ingram R.W., Albright T.L., Baldwin B.A. and Hill J.W. (2005) Accounting: Information for
Decisions, Third edition, Thomson South-Western: Canada
Jackson S. and Sawyers R (2006) Management Accounting, International Student Edition,
Thomson South-Western: Singapore
Lubbe I. and Watson A. (2006) Accounting: GAAP Principles, First edition, Oxford
University Press Southern Africa: Cape Town
Niemand A.A., Meyer L., Botes V.L. and van Vuuren S.J. (2004) Fundamentals of Cost and
Management Accounting, Fifth edition, LexisNexis Butterworths: Durban
Warren C.S. (2007) Survey of Accounting, Third edition, Thomson South Western: USA
Wood F. and Sangster A. (2005) Business Accounting, Tenth edition, Prentice Hall: China



TOPIC 1
ACCOUNTING INFORMATION AND MANAGERIAL DECISIONS

LEARNING OUTCOMES
Students should be able to:
identify the wide range of users of financial information.
describe the uses of financial information.
compare and contrast management accounting and financial accounting.
distinguish between the information needs of external and internal users.
explain the significance of internal auditing.
describe the role of the management accountant.
apply a basic decision-making model.
recognise the risk in decision-making.


CONTENTS

1. Introduction
2. Accounting information and managerial decisions
3. Internal auditing
4. The role of the management accountant
5. A basic decision-making model
6. Role of risk in decision-making
7. Self-assessment activities and solutions

READING
Prescribed
9
th
Edition, McGraw-Hill: New York. (Chapter 1)

Recommended
UK (Chapters 1 and 2)

Thomson South-Western: Singapore. (Chapter 1)


1. INTRODUCTION
The original purpose of accounting was to record transactions and present financial
statements. However, accounting has evolved and the American Accounting
Association sees accounting as the process of identifying, measuring and
communicating economic information to permit judgements and decisions by users of
information. A major focus of accounting now is the input that it provides for
decision-making.

2.

ACCOUNTING INFORMATION AND MANAGERIAL DECISIONS
All organisations large or small; manufacturing, retail or service; profit or non-
profit have a need for accounting information. The primary role of accounting is
to provide useful information for the decision-making needs of financiers (investors,
lenders, owners), managers and others both inside and outside the organisation.
Accounting is link between business activities and business decisions. Ingram et al
(2005: 59) uses the following model to describe the link:

Exhibit 1-1
Business
Activities

Operating
Investing
Financing

Accounting

Measuring
Recording
Reporting
Analysing

Business
Decisions

Actions Based on Business Decisions

Business environments have changed dramatically. Companies of all sizes now
compete in a dynamic global marketplace. Clients demand specialised products and
services and information relating to product availability, order status and delivery
times. Suppliers require information on their clients sales and stock levels in order
to tailor their production schedules and delivery times. Shareholders demand greater
returns and capital gains from their investments.

All these changes necessitate more effective management of knowledge within an
organisation. Organisations generate great volumes of data. Data becomes

information when it is organised, processed and summarised. Information becomes
knowledge when it is shared and exploited to add value to an organisation.

Accounting information includes both financial and non-financial information used
by decision-makers. Jackson and Sawyers (2006: 5) portray a contemporary view of
accounting information as follows:

Exhibit 1-2
Accounting information

Traditional Financial
Accounting
Information

Non-financial
Information

Financial
information
Balance sheet
Income statement
Cost of goods
manufactured
Gross profit
Operating expenses
Other quantitative
information
Percentage of defects
Number of customer
complaints
Warranty claims
Units in inventory
Budgeted hours
Qualitative
information
Customer satisfaction
Employee satisfaction
Product or service quality
Reputation

The responsibilities of accountants within an organisation tend to be split between the
main functions of financial accounting and management accounting. Financial
accounting is the area of accounting that is primarily concerned with the preparation
of general use financial statements for use by creditors, investors and other users
outside the business (external users). Management accounting, on the other hand, is
primarily concerned with generating financial and non-financial information for use
by managers in their decision-making roles within the organisation (internal users).



? THINK POINT
What are the information needs of external users?

The major differences between financial and management may be tabulated as
follows:

Management accounting Financial accounting
User groups Internal users: Managers External: Owner(s); Lenders,
Creditors; Investors
Nature of reports Reports tend to be specific usually
with some decision in mind.
Reports tend to be general-purpose
useful to a wide range of users.
Legal
requirements
Management accounting reports
are not required by law since they
are for internal use only.
Financial reports are required by law
and are also regulated in terms of
content and format.
GAAP Management accounting reports
are not subject to the practices and
principles of GAAP (Generally
Accepted Accounting Practice).
Financial reports must conform to
the practices and principles set by
GAAP.
Time focus The emphasis is on the future but
also provides information on past
performance.
It reflects on the financial result and
financial position for the past period.
Nature of
information
Information used may be less
objective and verifiable.
Objective and verifiable information
is needed to prepare reports.
Frequency of
reporting
Reports are produced as often as
required by managers even on a
weekly basis.
Reports are produced annually
although some businesses prepare
half-yearly or even quarterly reports.
Focus on the
whole or parts of
the business
Focuses on parts of the business
e.g. a certain department as well
as the business as a whole.
Focuses on the performance of the
business as a whole.



The information needs of external users (refer to think point above) may be
summarised as follows:
Investors have invested money in an enterprise. They require information on the
return on their investments and the financial position of the enterprise.
Creditors and lenders of money (e.g. banks) will be interested to know whether the
amounts owing to them will be paid on the due date.
Employees concern with accounting information has to do with job security,
employment opportunities and salary negotiations.
Government: Financial results are required by the government tax collection agency
to calculate the taxes payable to the government. Statistical analyses are also done by
the government to enable it to plan and draft policies.

The information needs of internal users (managers) may be summarised as
follows:
Information is needed to enable managers to make better and informed decisions.
Management requires a steady flow of information to respond to possible problems.
This information could be in the form of reports, spreadsheets, graphs etc. Managers
have to evaluate the information and make their decisions.
Up-to-date accounting information is needed for effective planning. Planning relate
to the setting of goals or objectives and the formulation of policy.
Information is also required for control purposes. It can help decision-makers to
determine that they are not where they want to be. The accounting information can
help them to determine what went wrong and what they might do get back on track.

3.

INTERNAL AUDITING
An annual audit of accounts is a legal requirement for public companies. According
to Davies and Pain (2002: 248) the main duty of external auditors is to report to
shareholders and others whether, in their opinion, the financial statements show a true
and fair view, and comply with statutory, regulatory and accounting standard
requirements. However, the report does not guarantee that the financial statements are
correct, that the organisation will not fail and that there has been no fraud. As a result
internal auditing became a necessity.


According to the Institute for Internal Auditors (UK) internal audit is an
independent appraisal function established within an organisation to examine and
evaluate its activities as a service to the organisation. The objective of internal
auditing is to assist members of the organisation in the effective discharge of their
responsibilities. To this end, internal auditing furnishes them with analyses,
appraisals, recommendations, counsel and information concerning the activities
reviewed.

The internal auditors report to the audit committee of the company. The committee
should consist of members of the board of directors who are not part of the
organisations management.

4. THE ROLE OF THE MANAGEMENT ACCOUNTANT
As a consequence of the advances made in accounting information systems and the
automation of accounting functions, the role of the management accountant has
shifted from collecting data to analysing information and creating knowledge from
this information. The role of management accountants is to interpret information and
put it into a suitable format for other managers, thereby facilitating management
decision-making. The work of management accountants often involves close co-
ordination with the financial, production and marketing functions of an organisation.

5.

A BASIC DECISION-MAKING MODEL
Decision-making, a key element of management accounting, is a process of
identifying various courses of action (alternatives) and selecting the most appropriate
one. Jackson and Sawyers (2006: 13) suggest a four-step decision-making model that
allows one to approach complex decisions in an orderly manner. Although the model
may not guarantee that all decisions will be correct, it does increase the probability of
making a good decision. The model may be illustrated as follows in Exhibit 1-3:


Exhibit 1-3
T Th he e D De ec ci is si io on n M Ma ak ki in ng g m mo od de el l

Step 4 Select the best option
Step 3 Identify and analyse available options
Step 2 Identify objectives
Step 1 Define the problem

Step 1: Define the problem
Defining the problem accurately is important as many decision-makers make bad
decisions through trying to solve the wrong problem. The input of managers of all the
functional areas is advised in order to get a clearer picture of the underlying problem.
For example, if the organisation is experiencing a problem with its control over
expenses, the co-operation of all functional mangers is essential in getting to the root
of the problem.

Step 2: Identify objectives
This step involves the identification of objectives in finding a solution to the problem.
The objectives may be quantitative (e.g. reduce expenses by 20 per cent) or
qualitative (train employees in cost reduction techniques) or a combination of both.

Step 3: Identify and analyse available options
The options available to attain the objectives must now be identified and analysed.
One must consider the relevant variables that affect the problem as well as alternative
courses of action. It is recommended that more than one option and multiple variables
be considered.

Step 4: Select the best option
The decision-maker must examine the extent to which each of the options will
achieve the objective(s). Decisions should be based on both quantitative and
qualitative information. It must be borne in mind that decisions are often made
against the backdrop of uncertainty and the element of risk is usually present. Once
the best option is selected, the decision is implemented and the results are evaluated.

6.

ROLE OF RISK IN DECISION-MAKING
As mentioned above, most decisions involve risk. The attitude of the decision-maker
towards risk has a significant influence on the option that is chosen. Decision makers
who are risk seekers will rate alternatives differently from decision-makers who are
risk-averse. For example, risk-averse decision makers may rate more highly a
machine needed in production that is made by established manufacturers than one
made by a new company.

Another way of adjusting for risk is by taking into account the possibility that
certain events may occur. For example, in the choice of a machine, it is possible that
the price of the machine may increase before the decision to purchase is made.

The third way of considering risk is to establish the sensitivity of the decisions to
changes in the key variables that were considered during the analysis. For example,
the purchaser of the machine may not be totally sure of getting the best financing
options from all the manufacturers. The purchaser may now consider the cost of the
machine taking into account all possible financing options. If this adjustment changes
the decision, then the decision is sensitive to changes in that variable. If not, then the
decision is not sensitive to that variable.

7.
7.1

7.1.1
7.1.2
7.1.3
7.1.4
7.1.5
7.1.6
SELF-ASSESSMENT ACTIVITIES AND SOLUTIONS
Accounting information is used by individuals and organisations for a variety of
reasons. Identify the type of accounting information that may be of interest to each of
the following potential users:
Loan manager of a bank
Labour union representing employees
Production manager
Shareholders
Sales managers
President of the company


7.2

Financial and management accounting information serve different purposes.
State whether the following phrases describe management accounting or financial
accounting:
7.2.1
7.2.2
7.2.3
7.2.4
7.2.5
7.2.6
7.2.7
7.2.8
Must adhere to GAAP
Future orientation
Reports results by segments
Focus is on past performance
Emphasises reporting on the whole company
Information is often less precise
Highly customisable
Reports are produced as often as required

7.3

Why do you think that the internal auditors of a public company should report to the
audit committee and not to the finance director?

7.4

Your company wants to replace the existing office computer. After a lot of thought
and investigation, you are now seriously considering three options. The basic
information about each computer is as follows (Note the basic price includes the
central processing unit (CPU) with 80 gigabite (GB) hard drive, keyboard and
mouse):

Basic price
Processor speed
Monitor (17 inch)
CD or DVD writer
Speakers
Upgrade hard drive
Microsoft office package
Total price
Computer A
R4 800
2.8 Gigahertz
R800 (ordinary)
R200 (CD)
R200
R350 (120 GB)
R1 200
R7 550
Computer B
R5 200
3.0 Gigahertz
R850 (ordinary)
R450 (DVD)
R250
R400 (160 GB)
R1 400
R8 550
Computer C
R5 400
3.2 Gigahertz
R1 300 (LCD)
R400 (DVD)
R200
R520 (200 GB)
R1 350
R9 170


Required
7.4.1

7.4.2

7.4.3

7.4.4
Define the problem that may have led to the consideration of replacing the existing
office computer.
What are the objectives in choosing a computer? Identify both quantitative and
qualitative objectives. Which is the most important objective to you? Why?
Given the circumstances in your company, what are the available options in choosing
a new computer? Name the quantitative and qualitative factors affecting these
options.
From the options available, which is the best choice? Why?

SOLUTIONS

7.1
7.1.1
7.1.2

7.1.3
7.1.4

7.1.5
7.1.6

Loan manager of a bank
Labour union representing
employees
Production manager
Shareholders

Sales managers
President of the company
Some examples include:
Ability to service debt and repay capital
Ability to compensate employees; job security

Production costs; budgeted figures
Profitability; Earnings per share; Net asset
value
Sales forecasts; actual sales; selling expenses
Profitability; market share; share price

7.2
7.2.1
7.2.2
7.2.3
7.2.4
7.2.5
7.2.6
7.2.7
7.2.8
Must adhere to GAAP
Future orientation
Reports results by segments
Focus is on past performance
Emphasises reporting on the whole company
Information is often less precise
Highly customisable
Reports are produced as often as required
Financial accounting
Management accounting

7.3

The responsibility for the system of recording transactions rests with the finance
director. The finance director could prevent crucial information from being passed
on to others in the organisation. The audit committee meets on several occasions
during the year and it offers a degree of objectivity.

7.4
7.4.1
7.4.2

7.4.3

7.4.4
A variety of answers are possible. The following is one example:
The existing computer has inadequate memory and is too slow.
Quantitative
Acquire a computer that has at least twice the memory capacity as the existing one.
Purchase at a reasonable price.
Processing speed must be great.
Qualitative
Computer components must be of good quality.
Use as less space as possible.
Available options: Computer B and C (Monitor of Computer A takes up too much
desk space.)
Quantitative factors
Memory size
Speed of processor
Qualitative factors
Desk space
Quality of components
Computer C
LCD monitor takes less space and is more aesthetically pleasing.
Adequate memory (200 GB).
Processor speed is suitable.
Price is reasonable.


TOPIC 2
FINANCIAL STATEMENTS AND ACCOUNTING CONCEPTS

LEARNING OUTCOMES
explain what transactions are.
describe the kind of information contained in financial statements.
describe the integration of the financial statements.
explain the purpose of financial statements.
outline the main accounting concepts.
outline the meaning and usefulness of the accounting equation.
show the effects of transactions on the accounting equation and subsequently on the
financial statements.


CONTENTS

1. What is a transaction?
2. Financial statements
3. Accounting concepts
4. Accounting equation

READING
Prescribed
9
th
Edition, McGraw-Hill: New York. (Chapters 2 and 4)

Recommended
Berry A. and Jarvis R. (2006) Accounting in a business context, Fourth edition, Thomson
Learning: London. (Chapter 3)

UK (Chapters 1 4)

Decisions, Third edition, Thomson South-Western: Canada. (Chapter F4)

Warren A.S. (2007) Survey of Accounting, Third Edition, Thomson South-Western: USA
(Chapter 1)


1. WHAT IS A TRANSACTION?
According to Warren (2007: 48) a transaction is an economic event that under
generally accepted accounting practice affects one or more elements of the financial
statements and must therefore be recorded. Transactions are initially recorded in
journals, then summarised in accounts in a ledger and the effects of them are later
reflected in the financial statements.

2.

FINANCIAL STATEMENTS
Financial statements report on the financial position of an organisation at a certain
point in time and the changes in the financial position over a period of time. The
financial statements and what they are intended to report on are illustrated below:

FINANCIAL STATEMENT REPORTS ON:
Balance sheet Financial position on a certain date.
Income statement Profit for a particular period.
Statement of changes in equity Investments by and distributions to owners.
Statement of cash flows Cash flows during the period.

The financial statements are usually accompanied by notes on the accounting policies
and detailed information about many of the amounts reflected in the financial
statements. The notes are intended to assist the reader of the statements by providing
additional information that is deemed necessary by the organisation and its auditors.

The kind of information contained in financial statements, financial statement
relationships and the purpose of financial statements are now discussed.

2.1

Balance sheet
The balance sheet reports on the financial position of an organisation at a specified
point in time. It is basically a summary of an organisations assets, equity and
liabilities at a point in time. This is in contrast to the income statement, statement of
cash flows and statement of changes in equity that report changes in the financial
position. The following is an example of a balance sheet in a simple form:


Exhibit 2-1
MVN ENTERPRISES
BALANCE SHEET AS AT 31 MARCH 20.6

ASSETS
Property, plant and equipment
Inventory (merchandise)
Accounts receivables
Cash
Total assets

EQUITY AND LIABILITIES
Equity
Liabilities
Non-current debt
Accounts payables
Total equity and liabilities
R

247 000
19 000
28 500
151 400
445 900

220 650

100 000
125 250
445 900

The two main sections of the balance sheet are:
* Assets
* Equity and liabilities

Notice that the amounts for these two sections are the same viz. R445 900.

This equality is also known as the accounting equation:
Assets = Equity + Liabilities
R445 900 = R220 650 + R225 250

The following are brief explanations of the items in the balance sheet:
Assets are the resources that are controlled by an enterprise from which economic
benefits will be derived either now or in the future.
Liabilities are claims on the assets of an organisation. Simply put, it refers to what
an organisation owes.
Equity or Owners equity may be viewed as the residual claim that the owner(s) has
on the assets of the organisation after all the liabilities have been settled. It normally
consists of two parts viz. that which is invested in the organisation and that which is
earned by the organisation and left in the organisation (i.e. retained profits).

Property, plant and equipment refer to non-current assets such as land, buildings,
vehicles, machines and equipment that have a useful life of more than one year.
Inventory refers to the merchandise that has been purchased but not yet sold.
Accounts receivable represents the amounts owing by customers for merchandise
sold to them on credit.
Cash represents cash on hand and cash kept at the bank.
Non-current debts are debts that are payable after more than one year from the
balance sheet date.
Accounts payable represents amounts owing to suppliers for merchandise purchased
on credit.

A major purpose of the balance sheet is to provide financial information to external
users. It is an important statement to creditors who require information about assets
and claims to these assets.

2.2

Income statement
The income statement reports on the profit (or loss) made by an organisation over a
certain period of time. It reflects the revenue generated through its operating
activities (e.g. sales) and then deducting the expenses incurred in generating that
revenue and operating the organisation. Losses and gains arising from non-operating
activities are also reported.

The following is a simplified format of an income statement:

Exhibit 2-2
MVN ENTERPRISES
INCOME STATEMENT FOR THE YEAR ENDED 31 MARCH 20.6
R
Sales 300 000
Cost of sales (200 000)
Gross profit 100 000
Selling, general and administrative expenses (54 950)
Operating profit/Income from operations 45 050
Interest expense (15 000)
Net profit 30 050


The statement starts with sales. The various expenses are deducted to arrive at the net
profit (or net income). Let us examine the items in the income statement.
Sales (sometimes called revenue) reflect the amount earned through the sale of
merchandise to customers less any sales returns.
Cost of sales reflects the cost of the merchandise sold to customers.
Gross profit (also called gross margin) is the difference between sales and cost of
sales. It represents the maximum amount from which all other expenses must be met
before a profit can be realised.
Selling, general and administrative expenses are the operating expenses of the
organisation. In a typical income statement, each expense is shown as a separate item
instead of being grouped together (as is the case here).
Operating profit is often used as a measure of the performance of management.
Interest expense represents the cost of borrowing funds.
Net profit will only result if the income exceeds expenses. A net loss results if
expenses exceed income.

A major purpose of the income statement is to meet the needs of investors who
require information about earnings (profit). In companies, this information about
earnings is useful for evaluating management decisions that affect payments to
shareholders and share prices.


2.3

Statement of changes in equity
The statement of changes in equity (owners equity) reflects the changes to the
components of the equity during the year. The following is a simplified format of a
statement of changes in equity:

Exhibit 2-3
MVN ENTERPRISES
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR
ENDED 31 MARCH 20.6

Balance at 31 March 20.5
Additional capital contributed
Profit for the year
Drawings for the year
Balance at 31 March 20.6
R
0
211 000
30 050
(20 400)
220 650

Balance at 31 March 20.5 includes the investment of the owner(s) in the
organisation as well as any retained profit from the previous year(s). In this example,
the organisation only commenced business on 01 April 20.5 and this is why the
balance at 31 March 20.5 is zero.
Additional capital contributed reflects an increase in the investment by the
owner(s) in the organisation during the year.
Profit for the year refers to the net profit available to the owner(s) as calculated in
the income statement.
Drawings for the year reflects the portion of the profit earned which has been
withdrawn by the owner(s) for personal use.

The purpose of a statement of changes in equity is to describe transactions regarding
capital (shares) and the amount and use of retained earnings.

2.4

Statement of cash flows
This statement reflects the sources of cash and how the cash was used during the
year. This is done by reporting on the changes in all the other balance sheet items.
The changes in all these other balance sheet items will equal to the change in cash.

The following is an example of a simple statement of cash flows:

Exhibit 2-4
MVN ENTERPRISES
CASH FLOW STATEMENT FOR THE YEAR ENDED 31 MARCH
20.6
R
Cash flows from operating activities 120 800
Operating profit 45 050
Non cash flow adjustment: Depreciation 13 000
Profit before working capital changes 58 050
Working capital changes: 77 750
Increase in inventory (19 000)
Increase in accounts receivable (28 500)
Increase in accounts payable 125 250
Cash generated from operations 135 800
Interest paid (15 000)

Cash flows from investing activities (260 000)
Non-current assets purchased (260 000)

Cash flows from financing activities 290 600
Cash received from owner 190 600
Cash received from non -current loan 100 000
Increase in cash 151 400

Cash flows from operating activities is a focal point for most stakeholders as an
organisation cannot survive in the long-term unless it generates sufficient cash flows
from its operating activities.
Depreciation is added back to profit as it is a book entry and cash is not affected.
The increase in inventory is subtracted because cash was paid to increase inventory.

The increase in accounts receivable is subtracted since it reflects sales that have not
yet been received.
The increase in accounts payable is added since cash has not been paid for products
or services received.
Cash flows from investing activities reflect the cash used to purchase assets that
have a long life.
Cash flows from financing activities include amounts received from the owner(s) to
increase capital and amounts received (or paid) through long-term borrowing.
The net increase in cash can be verified as it is also equal to the difference in the
cash balances at 31 March 20.5 (0) and 31 March 20.6 (R151 400).

The purpose of the statement of cash flows is to provide information to investors,
creditors and other users to assess the ability of the organisation to meet its cash
requirements.

2.5

Financial statement relationships
The financial statements of MVN Enterprises (discussed above) will be used to
illustrate the financial statement relationships. Refer to exhibit 2-5.

The balance sheet at 31 March 20.5 has no amounts since MVN Enterprises only
commenced business on 01 April 20.5. The integration of the financial statements is
as follows:
The net profit in the income statement also appears in the statement of changes in
equity as an addition to retained earnings. The net profit also affects the retained
earnings component of equity in the balance sheet.
The statement of changes in equity and balance sheet are integrated. The retained
earnings on 31 March 20.6 also appears as part of equity in the balance sheet.
The balance sheet and the statement of cash flows are also integrated. The cash that
appears in the balance sheet also appears as the end of the financial year cash in the
statement of cash flows.


Exhibit 2-5
F FI IN NA AN NC CI IA AL L S ST TA AT TE EM ME EN NT T R RE EL LA AT TI IO ON NS SH HI IP PS S
*31 March 20.5 Financial year 20.6 31 March 20.6*

MVN Enterprises
Statement of cash flows for the
year ended 31 March 20.6
Operating activities 120 800
Investing activities (260 000)
Financing activities 290 600
Net change in cash 151 400
MVN Enterprises Cash on 31 March 20.5 151 400 MVN Enterprises
Balance Sheet at 31 Mar 20.5 Balance Sheet at 31 Mar 20.6
Assets MVN Enterprises MVN Enterprises Assets
Cash - Income statement for the year Statement of changes in equity Cash 151 400
All other assets - ended 31 March 20.6 for the year ended 31 March 20.6 All other assets 294 500
- Revenue 300 000 Paid-in capital 211 000 445 900
Expenses (269 950) Retained earnings:
Equity & liabilities Net profit 30 050 Opening balance 0 Equity & liabilities
Equity Net profit 30 050 Equity
Capital - Drawings (20 400) Capital 211 000
Retained earnings - Closing balance 9 650 Retained earnings 9 650
Total equity - Total change in equity 220 650 Total equity 220 650
Liabilities - Liabilities 225 250
- 445 900



? THINK POINT
Davies and Pain (2002: 23) uses the imagery of a video cassette player with pause and play
buttons to associate with the financial statements viz. income statement, balance sheet and
statement of cash flows. Can you explain the imagery?

3.

ACCOUNTING CONCEPTS
Many important decisions are made from financial statements and it is important to
understand the principles or concepts that underpin the preparation of financial information.
These concepts are practices that accountants have agreed upon over a period of time.
Marshall et al (2011: 47) use the following model to illustrate the concepts:

Exhibit 2-6
Accounting entity

Assets = Equity + Liabilities Going concern
(Accounting equation) (continuity)
Procedures for sorting,
classifying, and presenting
(bookkeeping)

Selection of alternative
methods of reflecting the
effect of certain transactions
(accounting)

Transactions Financial statements

- Unit of measurement - Accounting period - Consistency

- Cost principle - Matching revenue and expense - Full disclosure

- Objectivity - Revenue recognised at time of sale - Materiality

- Accrual concept - Conservatism



3.1
The accounting concepts may be explained as follows:

Concepts related to the whole model
The accounting equation must be in balance every time transactions are recorded in the
accounting records.
Accounting entity refers to the entity (organisation) for which the financial statements are
prepared.
In terms of the going concern concept it is presumed that the entity will continue to operate
in the future. The amounts reflected in the balance sheet thus do not reflect the liquidation
value of the assets.

3.2

Concepts related to transactions
In South Africa, the Rand is the unit of measurement for all transactions. Adjustments are
not made to the buying power of the Rand.
In terms of the cost principle transactions are recorded at their original cost to the entity as
measured in Rands.
Objectivity ensures that transactions are recorded the same way in all situations. The use of
the Rand as a unit of measurement and the cost principle facilitates objectivity.

3.3

Concepts related to bookkeeping procedures and the accounting process
These concepts apply to the accounting period. The accounting period, which is usually
one year, is the period of time chosen to report on the results of operations and the financial
position.
In terms of the matching concept all income earned and expenses incurred to earn the
income are matched with each other to calculate the profit (or loss) for the period for which
they relate.
Revenue is recognised at the time of sale, which is when ownership of the product is
passed to the buyer.
In terms of the accrual concept revenue is recognised at the point of sale and expenses are
recognised as they are incurred, even if the cash receipt or payment occurs at another time
or in another accounting period.


3.4

Concepts related to financial statements
The consistency concept is based on the principle uniformity that prevails in the
accounting treatment of like items within each accounting period and from one period to
the next. This will ensure that meaningful comparisons can be made using an entitys
financial statements for several years.
Full disclosure requires that financial statements and notes include all the necessary
information that will prevent the users of the financial statements from being misled.
Information is regarded as material if its omission or misrepresentation could influence the
economic decision of users taken on the basis of the financial statements. The concept of
materiality also implies that the amounts reflected in the financials statements need not be
stated with absolute preciseness.
Conservatism in accounting requires accountants to be conservative when in doubt. When
the principle of conservatism is applied to making judgements, lower profits and asset
valuations are estimated rather than higher values.

4.

ACCOUNTING EQUATION
We already know that the accounting equation (derived from the balance sheet) is
expressed as follows:
Every financial transaction will cause a change in the accounting equation. However, the
equation will remain in balance after every transaction. The equation can be stated in an
expanded form as to include items in each of the three elements of the equation:

Equipment Inventory Receivables Bank = Capital Income Expenses + Payables

Note that income and expenses appear under equity as they are used to calculate the net
profit/loss that in turn increases/decreases equity.



The following example will be used to illustrate the operation of the accounting equation.
Example 1

02
06
10
14
28
31
Transactions for March 20.6
The owner of Tulani Enterprises commenced her business by investing R65 000 cash.
Purchased equipment for R15 000 cash.
The owner obtained a long-term loan of R30 000 from the bank.
Purchased merchandise on credit, R40 000.
Sold merchandise that cost R15 000 for R26 000 on credit.
Paid salaries to the employees, R6 000

Exhibit 2-7 illustrates the effect of the above transactions on the accounting equation.


Exhibit 2-7
Date Equipment Inventory Receivables Bank =
=
Capital Income Expenses +
+
Loan Payables
02
06
10
14
28

31

+R15 000

+R40 000

-R15 000

+R26 000
+R65 000
-R15 000
+R30 000

-R6 000
+R65 000

+R26 000

-R15 000
-R6 000

+R30 000

+R40 000
Total +R15 000 +R25 000 +R26 000 +R74 000 +R65 000 +R26 000 -R21 000 +R30 000 +R40 000

REMARKS
The transaction on the 28
th
is done over two lines as there are two effects. One shows the revenue and the other shows the cost of the
merchandise sold.
When an expense increases, one of the effects is that the owners equity will decrease. Thus for the entries on 28
th
and 30
th
March the
minus sign in the expenses column is to indicate that the owners equity is decreasing (not the expenses).


The simplified formats of the financial statements from the data from exhibit 2-7 are
presented below in exhibit 2-8:

Exhibit 2-8
TULANI ENTERPRISES
INCOME STATEMENT FOR THE MONTH ENDED 31 MARCH 20.6
R
Revenue 26 000
Expenses (21 000)
Net profit 5 000

TULANI ENTERPRISES
STATEMENT OF CHANGES IN EQUITY FOR THE MONTH
ENDED 31 MARCH 20.6

Opening balance
Net profit
Closing balance
R
0
65 000
5 000
70 000

TULANI ENTERPRISES
BALANCE SHEET AS AT 31 MARCH 20.6

ASSETS
Cash
Total assets

Equity
Liabilities
Long-term debt
Accounts payables
R

15 000
25 000
26 000
74 000
140 000

70 000

30 000
40 000
140 000


TULANI ENTERPRISES
STATEMENT OF CHANGES IN CASH FLOWS FOR THE
MONTH ENDED 31 MARCH 20.6
R
Cash flows from operating activities (6 000)
Net profit 5 000
Add (Deduct) items not affecting cash
Increase in inventory (25 000)
Increase in accounts receivable (26 000)
Increase in accounts payable 40 000
Cash flows from investing activities (15 000)
Purchase of plant, machinery and equipment (15 000)
Cash flows from financing activities 95 000
Capital contributed 65 000
Cash received from long-term loan 30 000
Net increase in cash for the year 74 000
Cash (opening balance) 0
Cash (closing balance) 74 000

5.
5.1
Indicate whether each of the following is regarded as a financing activity (F), investing
activity (I) or operating activity (O). Write down the letter F, I or O in the spaces provided.
5.1.1.
5.1.2
5.1.3
5.1.4
5.1.5
5.1.6
___
___
___
___
___
___
New machinery was purchased for installing in the factory.
A loan was obtained from the bank.
R1 000 was received from a customer for goods sold.
The organisations old computer was sold for R900.
The owner increased her capital contribution in the business.
Two more secretaries were employed.

5.2

A balance sheet may be said to represent assets and claims to assets. Who has claims to the
assets of an entity?
5.3 Assume that you are reviewing a balance sheet that has two sections viz. assets as well
equity and liabilities. What questions can you answer by examining the assets? What
questions can you answer by examining the equity and liabilities?

5.4 The income statement as well as the statement of cash flows provides information about
the operating activities during a financial year. Apart from possible statutory requirements,
why are both statements included in an organisations financial report? How can decision-
makers use of information in each statement?
5.5 You are considering a move from a small well-established retailer to a public company
that was established 18 months ago. You have a job interview next week. Your business
friends advised you to investigate the company before the interview. They say that if the
companys business plan fails, there is a great chance that the company may not be a going
concern. Name some questions that you would like to get answers to before the interview?
5.6 Discuss the implications of the preparation of the income statement if there were no
accounting concepts.
5.7 Valpre Enterprises had the following transactions during its first month of business, May
20.6.
May
01

Patricia Zuma set up a bank account in the name of the business and deposited R70 000 of
her own funds into the account.
04 She supplemented her capital by taking a long-term loan with her bank, R40 000.
05 The rent for May 20.6 was paid by cheque, R2 000.
12 Goods for resale costing R25 000 were purchased by cheque.
15 A cash register machine was purchased on account, R2 500.
20 Paid advertising costs for the grand opening of the firm, R3 500.
28 Employees were paid R2 800 in wages.
31 Sold goods that cost R13 000 for R25 000 on credit.

Required
5.7.1 Use the format presented in exhibit 2-7 to analyse the above transactions.
5.7.2 Use the total of the effects of the transactions (as calculated in 5.7.1) to prepare the:
5.7.2.1 Income statement for May 20.6.
5.7.2.1 Statement of changes in equity for the month ended 31 May 20.6.
5.7.2.2 Balance sheet on 31 May 20.6.


SOLUTIONS

? THINK POINT
The balance sheet is a financial snapshot at a moment in time. The financial position of an
organisation is comparable to pressing the pause button on a video player. The video in
play mode shows what is happening as time goes on. When you press pause the video
stops on a picture. However, this picture does not tell what has happened over the period of
time up to the pause.
The income statement is the video in play mode. Net profit is calculated from revenues
earned throughout the period between two pauses, minus expenses incurred from earning
those revenues.
The statement of cash flows is the video again in play mode. It summarises the cash
inflows and outflows and calculates the net change in the cash position throughout the
period between two pauses.

5.1
5.1.1.
5.1.2
5.1.3
5.1.4
5.1.5
5.1.6
I
F
O
I
F
O
New machinery was purchased for installing in the factory.
A loan was obtained from the bank.
R1 000 was received from a customer for goods sold.
The organisations old computer was sold for R900.
The owner increased her capital contribution in the business.
Two more secretaries were employed.

5.2

Firstly, the suppliers of credit and loans (liabilities).
Secondly, after liabilities have been settled, the investor(s) in the business.


5.3

Are the non-current assets optimally utilised?
Which non-current assets need replacement because they are reaching the end of their
economic life?
Are the investments providing a satisfactory return?
Are there any capital gains on the investment?
Is the organisation holding too much inventory?
Is there too much owing by debtors?
Is there too much of cash lying idle in the bank?
How much of borrowed capital is there compared to own capital?
Did the owner(s) get a satisfactory return on investment?
Will the business be able to make repayments on loans and service the debt?
Will the organisation be able to pay off its short-term debts?
To what extent is the organisation taking advantage of credit offered by suppliers?

5.4

The income statement shows how the profit or loss has been achieved during the year. It
does this by showing us the revenues that have been generated and the costs that were
incurred to generate those revenues. Consequently, it shows the increase or decrease in
wealth of the business during the period. The statement of cash flows on the other hand
describes the events that affected the organisations cash during the financial year. The
statement identifies how much cash an organisation has, where the cash came from and
how the organisation used the cash during the financial year.
Use of the statements by decision-makers
Owners and decision-makers use the income statement to evaluate how well the
organisation has performed. However, the income statement (or the balance sheet for that
matter) does not show or analyse the key changes that have taken place in an organisations
financial position that a statement of cash flows will reveal. For example:
how much capital expenditure (e.g. buildings, machinery) was made and how it was
financed?
what was the extent of the new borrowing and how much debt was repaid?
how much did the organisation need to fund increases in debtors and stock requirements?
how much of the companys funding was obtained from funds generated from its operating
activities and how much by new external funding?


5.5

Are there any published financial statements available for analysis?
How much has been invested in the company by shareholders?
Is the company profitable?
Is the company generating sufficient cash to meet its cash payments?
Are any analyses by the press available?
What is the present customer base?

5.6

If accountants prepare income statements as they see fit, comparability between
organisations and across time periods would be extremely difficult.
The lack of accounting concepts will open the way for accountants to manipulate figures in
the income statement. Some may window dress the income statement to make it look
better than it actually is. The reliability of figures in the income statement would then be
brought into question.


5.7.1
Date Equipment Inventory Receivables Bank =
=
Capital Income Expenses +
+
Loan Payables
01
04
05
12
15
20
28
31

+R2 500

+R25 000

-R13 000

+R25 000

+R70 000
+R40 000
-R2 000
-R25 000

-R3 500
-R2 800
+R70 000

+R25 000

-R2 000

-R3 500
-R2 800

-R13 000

+R40 000

+R2 500
Total +R2 500 +R12 000 +R25 000 +R76 700 +R70 000 +R25 000 -R21 300 +R40 000 +R2 500


VALPRE ENTERPRISES
INCOME STATEMENT FOR THE MONTH ENDED 31 MAY 20.6
R
Revenue 25 000
Expenses (21 300)
Net profit 3 700

VALPRE ENTERPRISES
STATEMENT OF CHANGES IN EQUITY FOR THE MONTH ENDED
31 MAY 20.6

Opening balance
Net profit
Closing balance
R
0
70 000
3 700
73 700

VALPRE ENTERPRISES
BALANCE SHEET AS AT 31 MAY 20.6

ASSETS
Cash
Total assets

Equity
Liabilities
Non-current debt
Accounts payables
R

2 500
12 000
25 000
76 700
116 200

73 700

40 000
2 500
116 200


TOPIC 3
ACCOUNTING FOR AND PRESENTATION OF ASSETS, LIABILITIES
AND OWNERS EQUITY

LEARNING OUTCOMES
identify the various current assets and report them correctly in the balance sheet.
explain why internal controls are important.
identify the various non-current assets and be able to report them in the balance sheet.
explain the different methods of depreciation for financial accounting purposes.
present the various current and non-current liabilities in the balance sheet.
describe how the components of owners equity are reported in the balance sheet.
interpret information presented in the balance sheet.


CONTENTS

1. Introduction
2. Assets
3. Owners equity
4. Liabilities

READING
Prescribed
9
th
Edition, McGraw-Hill: New York. (Chapters 5, 6, 7 and 8)

Recommended
Davies T. and Pain B. (2002) Business Accounting and Finance, First Edition, McGraw-Hill: UK
(Chapter 2)

Decisions, Third edition, Thomson South-Western: Canada. (Chapter F4)

Lubbe I. and Watson A. (2006) Accounting: GAAP Principles, First edition, Oxford University
Press Southern Africa: Cape Town. (Chapter 17)

(Chapter 5, 6, 7 and 8)


1.

INTRODUCTION
As previously mentioned, a balance sheet summarises an entitys assets, liabilities and
owners equity at a specific time in point. The focus of this topic is to make sense of the
presentation of assets, owners equity and liabilities in a balance sheet. The following
illustration (balance sheet of a company) is a picture of what is to follow:
Exhibit 3-1
BALANCE SHEET Paragraph
Non-current assets
Land
Buildings and equipment
Assets acquired by lease
Intangible assets
Natural resources
Other non-current assets
Current assets
Inventories
Notes receivable
Accounts receivable
Short-term marketable securities
Cash and cash equivalents

2.1
2.2
2.3
2.4
2.5
2.6

2.7
2.8
2.9
2.10
2.11
Owners equity
Ordinary shares
Preference shares
Retained earnings
Non-current liabilities
Long-term debt
Other long-term liabilities
Current liabilities
Accounts payable
Short-term debt
Current maturities of long-term debt

3.1
3.2
3.3

4.1
4.2

4.3
4.4
4.5


2.

ASSETS
Assets, as we already know, are the resources that are controlled by an enterprise from
which economic benefits will be derived either now or in the future. Assets may be
classified as current or non-current. Current assets include cash and those assets that are
expected to be turned into cash within one year. Non-current assets include land, buildings,
equipment, intangible assets and natural resources. Let us examine the presentation of
assets in the balance sheet.

2.1

NON-CURRENT ASSETS
Land
Land that is owned by an organisation is shown on the balance sheet at its original cost.
This is in keeping with the cost principle. The costs that the organisation incur to ensure
that the land is ready for use is regarded as being part of the original cost. These costs
include the purchase price of the land, legal fees and any other costs related to acquiring the
land. Land that is purchased for investment purposes is classified as a separate non-current
asset and is also reported at its original cost. No depreciation is calculated for land. If land
is sold, the profit or loss on the sale will be reported in the income statement during the
period in which the sale occurred.

2.2

Buildings and equipment
Building and equipment, like land, are reported at their original cost which includes the
purchase price and any other costs necessary to get them ready for use. Interest costs
incurred on loans acquired to finance the construction of buildings are capitalised (i.e.
recorded as an asset rather than an expense) until the buildings are ready for use. Costs that
are incurred to install new equipment are also capitalised.

In terms of the matching concept depreciation is calculated on buildings and equipment.
When buildings or equipment are purchased the original cost is regarded as a prepayment
of economic benefits that the organisation will reap in the future years. A part of the assets
cost is deducted from income that was generated through the use of the asset. Depreciation
expense is recorded in each financial year. In the balance sheet, the cost of the asset and its
accumulated depreciation (cumulative total of all the depreciation expense that has been
recorded over the life of the asset up to the balance sheet date) are reported as follows:



Buildings
Accumulated depreciation
R400 000
(80 000)

Net book value of buildings R320 000

It is more commonly reported as follows

Building, less accumulated depreciation of R80 000 R320 000

These are many methods of calculating depreciation that result in different patterns of
depreciation by financial year. The two broad categories of calculating depreciation are the
accelerated depreciation methods and the straight-line depreciation method. Accelerated
depreciation methods (e.g. declining balance and sum-of-the-years digits) result in a
higher depreciation expense (and thus lower net profit) in the early years of the life of the
asset. In the later years, deprecation expense will be less and net profit will be higher.
Using the straight-line method the depreciation expense is spread evenly over the life of
the asset.

? THINK POINT 1
According to a survey of American companies in 2000, it was found that 82% of companies
used the straight-line method to calculate depreciation. What motivation could there be for
the higher preference of the straight-line method.

When a depreciable asset is sold or scrapped, the cost of the asset and its accumulated
depreciation must be removed from the books. Profits or losses on disposal of depreciable
assets are not considered to be part of operating income. If the amount is material, it is
shown separately as either other income or other expenses. If the amount is not material, it
will be reported as miscellaneous other income.

2.3 Assets acquired by capital lease
Sometimes an organisation may lease (rent) an asset instead of purchasing it. If the lease
agreement results in the lessee assuming the benefits and risk of ownership of the leased
asset, it is called a capital lease. Such an asset will be reported in the lessees balance sheet

with the purchased assets. The accompanying liability will also be reported in the balance
sheet. In the lessees income statement the cost of the leased asset will be taken as the
depreciation amount and the financing cost will be reflected as interest expense.

2.4

Intangible assets
Marshall et al (2011: 213) defines an intangible asset as a long-lived asset represented by a
contractual right, or an asset that is not physically identifiable. One type of intangible asset
includes leasehold improvements, patents and trademarks; another type is called goodwill.
The cost of most intangibles is spread over time as expenses and this is known as
amortization. In other words the cost of an intangible asset from the balance sheet is
allocated to the income statement as an expense.
When a tenant makes modifications to the building it leases (e.g. constructing private
offices), the cost of such modifications (called leasehold improvements) is amortised over
their useful life to the tenant or over the life of the lease (whichever is shorter).
A patent is a licence granted by a government giving the owner sole control or use of an
invention for a period of 20 years.
A trademark is a name, term or symbol used to identify a business and its product.
Organisations can gain exclusive use of a trademark by registering it.
The exclusive right to publish and sell a literary, artistic or musical composition is granted
by a copyright.

The cost of obtaining a patent, trademark or copyright is capitalised and amortized over its
estimated useful life or statutory life (whichever is shorter). The cost of developing a
patent, trademark or copyright is usually not significant compared to purchasing them from
another organisation.

Goodwill refers to an intangible asset of an organisation that is created from such
favourable factors as good location, product quality, reputation, high customer loyalty and
managerial skill. Goodwill is recorded in the accounts only after it is determined
objectively by a transaction e.g. purchase of an entity for more than the market value of the
net assets. The excess is recorded as goodwill and reported as an intangible asset and is not
amortized. However, goodwill is tested annually for impairment. If the book value of the
goodwill is greater than the fair value, an impairment loss is realised equal to that excess.
The impairment loss is recorded in the income statement and the book value of the goodwill
will be decreased in the balance sheet.

2.5

Natural resources
Paper, petroleum and mining companies purchase or lease land that contains oil, wood or
minerals. The cost of the land primarily reflects the natural resources. The amount that is
reported for natural resources in the balance sheet is the cost of the asset minus depletion.
Depletion is the allocation of the cost of the natural resources to the periods that benefited
from their use.

2.6

Examples of other non-current assets include long-tem investments and notes receivable
that mature more than 12 months after the balance sheet date. When they become
receivable within a year, they will be re-classified as current assets.

2.7

CURRENT ASSETS
Inventories
Inventories in service organisations consist mainly of office supplies and other items of a
relatively low value. For manufacturing and merchandising organisations, the sale of
merchandise is the most important source of operating income. Cost of sales is usually the
largest expense that is deducted from sales to determine net profit. For these entities
inventories is an important current asset. Turning over inventory as quickly as possible will
enhance return on investment. The cost of items of inventory purchased includes not only
the invoice amount but also other purchasing costs e.g. freight and materials handling
charge.

There are several accepted practices of valuing inventory for reporting purposes. Inventory
valuations (and thus cost of sales) differ from method to method due to the change in the
cost of items of inventory during the financial year. The specific identification, weighted
average, first-in first-out (FIFO) and last-in first-out (LIFO) methods will now be briefly
discussed.

According to the specific identification method, when an item is sold the cost of the item is
obtained from the entitys records. This amount is transferred from the Inventory account to
the Cost of sales account. The cost of the items held in inventory at the end of the year will
be disclosed in the balance sheet.


The weighted average is applied to individual items of inventory. The average cost is
weighted by taking into account the number of units of opening inventory and each
purchase. This average is used to calculate the cost of sales and the value of closing
inventory.
The first-in first-out (FIFO) method transfers to the Cost of sales account the oldest costs
incurred in purchasing the inventory that was sold and thus values closing inventory at the
most recent costs of the merchandise purchased.
Under the last-in first-out (LIFO) method, the most recent costs of the merchandise
purchased are taken as Cost of sales and the closing inventory is valued at the oldest costs.

It is clear from the above that inventory valuation has an impact on both profitability and
liquidity. The impact of each of the four methods described above must be understood in
making judgements and decisions especially when comparing different entities. Consider
the following:
When costs are increasing during the year, the cost of sales will be lower and profits higher
under FIFO than under LIFO. The reverse happens when costs decrease during the year.

Inventories are reported in the balance sheet at the lower of cost or market. Sometimes
for some items of inventory the market value is lower than cost due to factors such as
obsolescence or damage. Reporting inventory at lower of cost or market is the application
of the accounting concept of conservatism.

2.8

Notes receivable
If a debtor experiences difficulty in settling a debt on due date, the entity may convert the
debt to a note receivable. The effect of this on the balance sheet is that accounts receivable
will decrease and notes receivable will increase. A note usually includes provisions relating
to maturity date, some form of security, penalties for non-payment and interest rate
associated with the loan. A note receivable may also be used when an entity lends money to
another entity and takes a note from that entity.


2.9

Accounts receivable
Accounts receivable refer to amounts receivable from customers for merchandise sold or
for services rendered on credit. Accounts receivable are reported at net realisable value i.e.
the amount expected to be received from debtors. The net realisable value is less than the
amount of the receivable originally recorded because of bad debts and cash discounts.
Despite doing a thorough check on the creditworthiness of customers, losses through bad
debts are inevitable. The credit manager is expected to estimate as accurately as possible,
from the accounts receivable, the expected bad debts (known as allowance/provision for
bad debts). Obviously, recent collection experience and the current economic conditions
prevailing would be taken into account. An adjustment entry is made to reduce the carrying
value of the accounts receivable. The presentation of allowance for bad debts under current
assets in the balance sheet is as follows:

Accounts receivable
Allowance for bad debts
R20 000
(1 000)
Net accounts receivable R19 000

Cash discounts are often allowed to debtors if the account is paid within a stated period
e.g. within 10 days of the date of sale. Credit terms allowed to customers usually state that
if the amount owing is not paid within the discount period, it must be paid in full within 30
days of the invoice date. The credit term is often abbreviated as 2/10, n30. In the balance
sheet, accounts receivable is reduced to allow for the estimated cash discounts that are
expected to be granted to debtors who pay within the discount period. The accounting
treatment of cash discounts is similar to that of allowance for bad debts.

2.10 Short-term marketable securities
An entity can improve its return on investment by investing cash that is not required for
daily operations in short-term marketable securities. For this to materialise, the drawing up
of cash budgets is essential. Marketable securities that mature with one year of the balance
sheet date are presented as cash equivalents (part of current assets) in the balance sheet. A
security that is held to its maturity date is reported in the balance sheet at cost since it is
usually the same as its market value. Debt and equity securities that may be classified as
trading or available-for-sale are reported at market value. Furthermore, any unrealised
profit or loss is recognised.

2.11

Cash includes money kept for change, petty cash funds, undeposited cash and cash
immediately available to the organisation in its bank accounts. Cash equivalents are short-
term investments readily convertible into cash. Since cash on hand and cash in cheque
accounts earn little or no interest, there must be a cash management system in place to
invest cash that is not currently required for the organisations operation. Management must
also have policies in place to reduce the chances of embezzlement of cash.

? THINK POINT 2
As a financial manager, what control measures would you put in place to reduce the
chances of embezzlement of cash by employees?

An internal control system is important in the management of cash and may consist of
financial and administrative controls. Using financial control, there must be a separation of
duties i.e. more than one person must be responsible for a transaction from beginning to
end. Administrative controls are usually included in policy and procedure manuals e.g.
investigation of a customers creditworthiness before credit is granted. The process of bank
reconciliation is also a form of internal control.

3.

OWNERS EQUITY
A company issues share capital to its shareholders under certain conditions and with certain
rights and obligations. The owners equity of a company (also called shareholders equity)
is made up of the capital provided by shareholders to the company, plus the net profit (after
tax) and gains retained in the company, less any dividends distributed to shareholders.

3.1

Ordinary shares
The ordinary shareholders are the ultimate owners of the company. They have a claim to all
the assets that remain in the company after all liabilities and preference shareholders claims
have been settled. Ordinary shareholders are not entitled to receive any stated dividend
amount and could even not receive dividends in some years at all. They have the right to
elect the directors of the company.


The ordinary share capital can be issued at its par value (monetary value assigned to a
share), or at a premium (higher than the par value). Ordinary shares with a par value are
reflected in the share capital account. Ordinary shares with no par value are reflected in
the stated capital account. When par value shares are issued at a premium, the amount of
the premium received is reflected in a separate account called share premium account.
Shares with no par value obviously cannot be issued at a premium.

3.2

Preference shares
Preference shares are usually sold after the first issue of ordinary shares. These shares may
be cumulative, non-cumulative, participating and/or redeemable. However, they are all
entitled to a fixed dividend from the profits before any other shares participate. They also
enjoy priority for return of capital if the company winds up. Cumulative preference
shareholders are entitled to a fixed dividend every year but any arrear dividends must be
made up for in subsequent years. Holders of participating preference shares, having
gained a fixed dividend each year, may also share in any of the profits that remain after
ordinary dividends are paid. Redeemable preference shares may be issued with optional or
compulsory rights of redemption (where capital is paid back). Preference shares may be
sold at par or at a premium. When they are issued at a premium, the premium received is
recorded separately in the share premium account.

3.3

Retained earnings
The retained earnings (retained income) account shows the cumulative profits of the
company that has been retained for use in the company rather than being distributed as
dividends to the shareholders. This account can only be changed for the following reasons:
Previous year adjustments (for correction of error or change in accounting policy)
Transfer of current year net profit
Declaration of current year dividends (ordinary and preference)
Transfers to other reserves
Release of other reserves
Write-off of share-issue costs that exceed costs written off against the share premium
account.


3.4

Disclosing shareholders equity
A separate statement of changes in equity must show, on the face of the statement:
the net profit (or loss) for the period.
each income or expense for the period that is recognised directly in equity.
the cumulative effects of changes in accounting policy and correction of errors.

The following changes can be presented in the statement of changes in equity or in the
notes to the financial statements:
transactions with the shareholders, with distribution to shareholders shown separately.
balance of accumulated profit (or loss) and any movements in this account.
reconciliation between carrying values of each class of equity, showing details of each
change.

The following is a summary of the note disclosure requirements related to the equity of a
company:

3.4.1

Authorised share capital
This must be stated specifying the classes of shares, number and nominal value of par value
shares in each class and number of no par value shares in each class.
3.4.2

Issued share capital
The sale of new shares, the issue of rights and any other increases to the share capital must
be disclosed in the statement of changes in equity. Likewise any decreases in share capital
(e.g. redemption of preference shares) must also be disclosed.

3.4.3 Share premium
This should be shown under issued capital and grouped with the particular share to which it
relates.
3.4.4 Redeemable preference shares
The following should be stated:
the earliest and latest dates on which the company has the power to redeem.
whether the shares must be redeemed at a fixed future date as well as whether they are
redeemable at the option of the shareholders or the company.
the dividend rights of these shareholders.


3.4.5 Directors authority to issue shares
The following should be stated by way of a note:
Number of shares or amount of share capital directors are authorised to issue.
Period for which authority is granted.
Terms of the authority.
3.4.6 Movements in reserves
A company must state the nature and purpose of each reserve. The opening and closing
balances and movements in each reserve should be disclosed.
3.4.7 Dividends declared and/or paid
The total amount of the dividends paid or declared for each class of share must be disclosed
in the statement of changes in equity.

4.

LIABILITIES
As noted previously, liabilities are the claims that creditors have on the assets of the
organisation. Liabilities that must be settled within 12 months of the balance sheet date are
called current liabilities while those that will be paid more than 12 months after balance
sheet date are called non-current liabilities. Liabilities are presented under current and
non-current categories in the balance sheet in order of liquidity i.e. how soon the obligation
is payable. Let us examine the presentation of liabilities in the balance sheet.

4.1

NON-CURRENT LIABILITIES
Long-term debt
Many organisations rely on debt and owners equity to finance the purchase of assets.
Although interest has to be paid on borrowings, interest expense is tax-deductible.
Furthermore, if an organisation can borrow money at an interest rate of 12 % and use the
money to purchase assets that realise a return that is greater than 12%, then the owners
would get a greater return on investment than if they provided the funding. The use of debt
with a fixed interest rate that causes a difference between the return on investment and
return on equity is called financial leverage. The possibility of a positive financial leverage
favours the use of long-term debt by organisations.


4.2

Other long-term liabilities
These liabilities include pension obligations, other post-retirement benefit plan obligations
(e.g. medical and hospitalisation benefits to retired employees), warranty obligations and
estimated values of lawsuits in progress.

4.3

CURRENT LIABILITIES
Accounts payable
Accounts payable arise from amounts payable to suppliers for goods and services that have
been supplied on credit. Most suppliers require payment within a relatively short period of
time. When reporting accounts payable in the balance sheet, cash discounts that may be
expected to be received for prompt payment is not deducted. In keeping with the materiality
concept, the amount involved is unlikely to influence the financial position or results of
operations.

4.4

Short-term debt
Organisations sometimes obtain short-term loans in order to increase inventory and to be
able to make payments for various expenses. These loans are expected to be repaid from the
proceeds of the sale of inventory. Loans have a specific maturity date unless a revolving
credit facility is negotiated. Interest payable on loans is reported in the income statement in
the year during which the money was owed.

4.5

Current maturities of long-term debt
Long-term loans are usually payable in instalments. Each year a portion of the loan is
repaid. Any portion of a long-term debt that is payable within 12 months of the balance
sheet date is reclassified from a non-current liability to a current liability. This portion of
the debt is reported as Current maturities of long-term debt in the balance sheet.


5. SELF-ASSESSMENT ACTIVITIES AND SOLUTIONS
5.1 Listed below are the account balances and other information for Reno Ltd for the financial
year ended 30 September 20.6.
(Note: The net profit after tax for the year ended 30 September 20.6 amounted to R58 000.)

Accounts payable
Accounts receivable
Buildings
Cash (in bank)
Ordinary share capital
Dividends (declared and paid)
Share premium
Equipment
Goodwill
Income tax payable
Interest payable
Land
Long-term investments
Merchandise inventory
Loan payable, current portion
Long-term loan
Prepaid insurance
Retained earnings (30 September 20.5)
Consumable inventory
Wages payable
R
44 000
22 000
328 000
824 000
32 000
550 000
34 000
50 000
490 000
26 000
12 000
28 000
70 000
70 000
124 000
20 000
556 000
14 000
50 000
26 000
36 000

Required
From the information provided above, calculate the amount to be reflected for each of the
following items for the Balance sheet of Reno Ltd for the year ended 30 September 20.6:
5.1.1 Land, buildings and equipment
5.1.2 Intangible assets
5.1.3 Other non-current assets
5.1.4 Current assets
5.1.5 Total assets

5.1.6 Total owners (shareholders) equity
5.1.7 Retained earnings (on 30 September 20.6)
5.1.8 Non-current liabilities
5.1.9 Current liabilities
5.1.10 Total liabilities
5.1.11 Total owners equity and liabilities

5.2

5.3

5.3.1
5.3.2

5.4

5.5

5.6
One of the facts that credit rating agencies and credit grantors want to know about an entity
when evaluating its liquidity (ability to pay short-term debts) and creditworthiness is
whether or not the entity consistently takes advantage of cash discounts. How will credit
grantors interpret an entity that does not consistently take advantage of cash discounts?

The annual credit sales of RNI Ltd is R400 000. The company grants a 2% cash discount
for payment within 10 days of invoice date. Eighty percent of the accounts receivable is
paid within the discount period.
Required
Calculate the total cash discounts allowed during the year.
Calculate the approximate annual rate of return on investment that the companys discount
terms represent to customers who take the discount.

What is the impact of the carrying value of inventory (in the balance sheet) and the cost of
goods sold (in the income statement) when LIFO rather than FIFO is used during periods of
inflation?
Balance sheet values usually do not represent the fair value of assets that have a long life.
Do you agree with this statement? Motivate your answer.

Compare the relative effect on the income statement and balance sheet of accelerated
depreciation methods and straight-line methods.

5.7

The balance sheet and accompanying notes provide useful information relating to a
companys debt. What information would readers be looking for?

5.8

Preference shares generally pay a higher return to investors than do bonds but a smaller
return than earned by ordinary shareholders. Why?

SOLUTIONS

? THINK POINT 1
In the early years of an assets life the straight-line method results in a lower depreciation
expense and a higher net profit than accelerated depreciation. In later years, when
accelerated depreciation is less than straight-line depreciation, total depreciation using the
straight-line method will still be lower than under accelerated method if the investment in
assets has increased each year as is typical for organisations that are growing.

? THINK POINT 2
Some measures would include the following:
Daily amounts of cash on hand at the end of the day must match receipts, cash register
tapes and bank deposits.
All receipts must be banked intact the next banking day.
The cashiers duties should be confined to receiving cash only. The cash receipts journal
and bank deposits should be prepared by other clerks.
Division of duties should apply. No person must control a transaction from data capture
until recording in the ledger.
Cheques should not be cashed by the cashier from monies received.
An independent senior staff member should daily unlock the cash register, record its
total, remove the printed tape, clear the cash register and balance the cash.
All payments except petty cash payments should be made by cheque or by electronic
transfers.
Cheques should be signed by two persons. These persons should not handle cash, or
authorize payments or record transactions in the books of account.
Payments should only be made when supported by authorised vouchers.
A bank reconciliation statement must be prepared monthly.


5.1.1

Land, buildings and equipment
Land
Buildings
Equipment
R
70 000
824 000
490 000
(328 000)

1 056 000

5.1.2

Intangible assets
Goodwill
R
26 000

26 000

5.1.3

Long-term investments
R
70 000

70 000

5.1.4

Current assets
Merchandise inventory
Consumable inventory
Accounts receivable
Prepaid expenses (insurance )
Cash
R
124 000
26 000
22 000
14 000
32 000

218 000

5.1.5

Total assets
Land, buildings and equipment
Intangible assets
Current assets
R
1 056 000
26 000
70 000
218 000

1 370 000

5.1.6

Total owners equity
Ordinary share capital
Share premium
Retained earnings (refer to 5.1.7)
R
550 000
50 000
74 000

674 000

5.1.7

Retained earnings
Balance (30 September 20.5)
Net profit
Dividends
R
50 000
58 000
(34 000)

Balance (30 September 20.6) 74 000

5.1.8

Long-term loan
R
556 000

556 000

5.1.9

Current liabilities
Accounts payable
Income tax payable
Accrued expenses (Interest
R28 000 and Wages R36 000)
Loan payable, current portion
R
44 000
12 000

64 000
20 000

140 000

5.1.10

Total liabilities
Current liabilities
R
556 000
140 000

696 000

5.1.11

Total owners equity and
liabilities
Owners equity
Total liabilities

R
674 000
696 000

1 370 000

5.2

It is an indication that management does not understand the significance of cash discounts.
It is probably unaware that the percentage cash discount, when converted to an annualised
return on investment, can be a very attractive return.
It may appear to credit grantors that the entity cannot borrow money at a lower interest rate
to earn the higher rate from the cash discount.
For any of the above reasons, the credit grantors may consider the entity to be a poor credit
risk.

5.3
5.3.1

(R400 000 X 80%) X 2% = R6 400
5.3.2 R6 400 X 100
R393 600

= 1,63 %

for 20 days

Annualised return = 1,63 % X 18 = 29,3%
Remarks:
If the invoices are paid by the 10
th
day, a discount of R6 400 is allowed and the customers
give up the use of R393 600 paid for 20 days because the alternative is to keep the money
for another 20 days and pay R400 000 to RNI Ltd. So, by choosing not to pay within 10
days, the customers are borrowing R393 600 for another 20 days at a cost of R6 400.
The return on investment for 20 days is 1,63% (calculated above). However, there are 18
available 20-day periods in a year (360 days/20). Thus the annualised return is 29,3%.

5.4

During periods of inflation (when costs are rising), LIFO results in a lower closing
inventory and a higher cost of goods sold than FIFO. This is because the LIFO assumption
results in the most recent, higher, costs being transferred to cost of goods sold (cost of
sales).

5.5

The cost principle requires assets to be recorded at their original cost. The balance sheet,
thus, does not show the market value or replacement value of the assets that have a long
life. Land, for example, that may have been acquired 20 years ago is reported at its original
cost even though its current value is much higher.
Furthermore, the carrying values reflected for assets such as vehicles, equipment and
machinery depend on the amount of depreciation that has been calculated and recorded.
The depreciation expense itself is an estimate as the useful life of the asset and its salvage
value are estimated.


5.6

In the financial year in which the asset is purchased, the operating income (calculated in the
income statement) will be higher if the straight-line method is used (since the depreciation
expense will lower than for the accelerated methods). The carrying value of the asset
(reflected in the balance sheet) will also be higher if the straight-line methods are used.
As time passes, depreciation per annum decreases using accelerated methods and a stage
will be reached when the operating income will be higher than straight-line methods. Also
as time passes, using accelerated methods, the carrying value of the assets in the balance
sheet will decrease at a lower rate compared to straight-line methods.

5.7

* The amount of debt that the company has outstanding.
* The changes in debt.
* The interest rates on debt.
* Current and future cash flows associated with the existing debt.

5.8

Return on investment is closely related to risk. Preference shares have dividend and
liquidation preference over ordinary shares. Liquidity preference means that in the event of
the company being liquidated, preference shareholders are repaid for their investments
before ordinary shareholders but after creditors (including bonds). Therefore preference
shares are less risky as an investment than ordinary shares but are more risky than bonds.


TOPIC 4
INCOME STATEMENT AND CASH FLOWS

LEARNING OUTCOMES
explain what revenue is.
determine cost of sales using the periodic and perpetual inventory systems.
explain the significance of the gross profit ratio.
report the components of other operating expenses.
outline the significance of income from operations
calculate earnings per share.
describe the purpose and format of the statement of cash flows.
present cash flows from operating activities using the direct and indirect methods.
outline the significance of the statement of cash flows to investors and other analysts.


CONTENTS

1. Income statement
2. Statement of cash flows

READING
Prescribed
9
th

Recommended
(Chapter 4)

Decisions, Third edition, Thomson South-Western: Canada. (Chapters F4 and F5)

Press Southern Africa: Cape Town. (Chapters 11-15 and 18)

(Chapter 4)


1.

INCOME STATEMENT
The income statement, as we already know, provides an indication of the financial results
of an entity for the financial period under review. It achieves this by reporting on the
income, expenses and net profit for a financial period. Income results from economic
benefits flowing to the entity because of various transactions with third parties, other than
the owners of the entity. Income includes both revenue and gains. Revenue is generated in
the course of ordinary activities of an entity e.g. sales, rent, fees. Gains are other items that
meet the definition of income and do not necessarily arise from the course of the ordinary
activities of the entity. Expenses are decreases in economic benefits in the form of outflows
or depletion of assets or the incurrence of liabilities that result in a decrease in equity
excluding distribution to equity participants.

The following exhibit represents a simple framework of the main items that are reported in
an income statement.

Exhibit 4-1
INCOME STATEMENT Paragraph
Sales
Cost of sales
Gross profit
Other operating expenses
Income from operations
Interest expense
Interest income
Gains (losses) on sale of assets
Income tax expense
Net profit
Earnings per share
1.1
1.2
1.3
1.4
1.5
1.6
1.6
1.6
1.7
1.8
1.8


We now examine how the above items are reported in the income statement.
1.1

Sales
Sales reflect the amount an entity earns through selling products that it has purchased or
manufactured. In terms of the accrual basis of accounting, revenue from the sale of goods is
recognised when earned, and this may not necessarily coincide with the timing of the
receipt of cash. If a customer returns merchandise, the customer may be given a cash refund
(if sales were for cash) or the accounts receivable may be decreased (in respect of credit
sales). Sometimes an allowance is given to a customer instead of having the goods returned.
These sales returns and allowances are recorded separately for internal control purposes
but the amount is subtracted from sales to arrive at net sales. Cash discounts to customers
are also deducted from sales to arrive at net sales. Some companies show how the net sales
are calculated by means of a note to the financial statements.

? THINK POINT 1
A customer ordered and paid for equipment that has still to be manufactured, so the
equipment is presently not available for sale. How will this be accounted for in the financial
statements?

1.2

Cost of sales
Cost of sales is the cost of the merchandise sold to customers. In compliance with the
matching principle cost of sales is recognised concurrently with the income it relates to viz.
sales. The determination of the cost of sales amount depends on:
* The practices used for valuing inventory viz. FIFO, LIFO, Weighted average (topic 3).
* The inventory accounting system used viz. periodic or perpetual.

Under the perpetual inventory system, when merchandise is sold its cost (as calculated
according to the practice for valuing inventory e.g. FIFO) is transferred from the inventory
account (asset) to the cost of sales account (expense). The important thing about the
perpetual inventory system is that the cost must be determined when the sale takes place.
The use of bar code scanners have facilitated the use of the perpetual inventory system.


In the periodic inventory system, physical stocktaking of the inventory on hand is done
periodically (including the end of the financial year) and the cost of inventory on hand is
then determined. The cost of sales is then calculated as follows (figures included to
illustrate the calculation):

Exhibit 4-2

Cost of opening inventory
+ Net purchases
R
40 000
120 000
= Cost of goods available for sale
Cost of closing inventory
160 000
(50 000)
= Cost of sales 110 000

When using the periodic inventory system freight expenses as well as purchases returns and
allowances are accounted for in separate accounts and each account balance is classified
with purchases. Net purchases is then calculated as follows:

Exhibit 4-3

Purchases
+ Freight charges
Purchases returns and allowances
R
118 000
5 000
(3 000)
Net purchases 120 000

1.3

Gross profit
Gross profit (also called gross margin) is the difference between sales revenue and cost of
sales. If the net sales of an entity is R200 000 and the cost of sales is R110 000 (using the
amount from exhibit 4-2), then the gross profit will be reported as follows:
Exhibit 4-4

Net sales
Cost of sales
R
200 000
(110 000)

Gross profit 90 000

When the gross profit is expressed as a percentage of sales, this ratio is called the gross
profit ratio (or gross margin ratio). Using the figures from exhibit 4-4, the gross profit
ratio is calculated as follows:

Exhibit 4-5
Gross profit ratio = Gross profit X 100
Net sales

= R90 000 X 100
R200 000

= 45%

This ratio is of significance to managers in the following ways:
Since the ratio measures the amount of each Rand of sales that is available to cover
operating expenses and profit, one of its main uses is to determine whether the entity is
operating at a level of sales that will lead to profitability in the current period. Managers
will know from past experience the gross profit ratio that is required to be profitable.
The gross profit ratio can be used to estimate the cost of sales and closing inventory for
periods in which physical stocktaking was not done. An estimate of inventory destroyed by
fire, floods or other natural disasters can be made.
The gross profit ratio is also used to set selling prices. If the gross profit ratio needed to
achieve profitability at a given level of sales is known, the selling price can be determined
by dividing the cost of the item by the complement of the gross profit ratio. This can be
demonstrated by using the figures from exhibits 4-4 and 4-5. If the cost price of the goods
is R110 000 and the gross profit margin is 45%, then the sales amount is calculated as
follows:
Sales = Cost of sales
100% Gross profit margin

=

=

R110 000
100% 45%

R200 000


1.4

Other operating expenses
Operating expenses are the costs of resources used as part of the operating activities during
a financial period and are not directly associated with specific goods and services.
Operating expenses include selling expenses, general and administrative expenses, and
research and development expenses.

These categories may be combined in a variety of ways for the purpose of financial
reporting e.g. selling, general and administrative expenses. Details of the nature and amount
of expense items that are combined in the income statement are sometimes disclosed by
means of a footnote to the financial statements. However, some operating expenses are
shown as separate items to highlight their significance e.g. advertising. Depreciation and
amortization expense is reported as a separate item in the income statement (or explanatory
notes) as it does not involve the payment of cash.

1.5

Income from operations
Income from operations is the difference between the gross profit and operating expenses.
The significance of this amount is that it is often used to measure the ability of management
to utilize the entitys operating assets. Interest income, interest expense, gains and losses,
income tax and other non-operating transactions are excluded from income from
operations. Many investors thus prefer to use income from operations rather than net profit
to assess the profitability of the entity.

1.6

Interest, gains and losses
These are non-operating items that are reported after income from operations.

Interest expense must be disclosed separately on the face of the income statement as
finance costs. Many users of financial statements would be interested in the interest
expense as it represents an obligation that must be honoured. The greater the interest
expense an entity incurs, the greater the risk will be to shareholders on their investment.

Revenue items, with the exception of sales, are included with other income on the face of
the income statement and details of revenue are presented in the notes to the financial
statements. Items that must be disclosed include interest income and dividends earned.

Gains and losses result from increases in the carrying value of assets and liabilities that do
not result from the ordinary operating activities of the entity. When the nature and amount
of transactions are important to the understanding of the entitys financial performance and
about the financial position of that entity, gains and losses from the disposal of property,
plant and equipment should be disclosed separately from the disposal of long-term
investments. Significant gains and losses should be disclosed separately in the notes to the
financial statements including the tax effect thereof. Gains are normally included as part of
other income. Some of the gains and losses that should be separately disclosed in the
notes to the financial statements include profits and losses from property, plant and
equipment, foreign exchange gains and losses, profits and losses from sale of intangible
assets, and profits and losses from the sale of financial instruments.

1.7

Income tax expense
The income tax levied on South African companies is termed SA Normal Tax and is
levied on the companys taxable income. In addition to normal tax, a company is charged
with Secondary tax on companies (STC) on the net dividends declared during its
dividend cycle. The tax expense of the entity should be disclosed on the face of the income
statement and the taxes payable are included in current liabilities in the balance sheet.

? THINK POINT 2
Income tax is levied on a companys taxable income. Why do you think that income tax is
not levied on the companys net profit before tax?

1.8

Net profit and Earnings per share
Arithmetically, the net profit (or loss) is the difference between revenues and gains on the
one hand and expenses and losses on the other. Since net profit is a prerequisite for
dividends, shareholders and potential investors are especially interested in the net profit.

To facilitate the interpretation of the net profit (or loss), the earnings per (ordinary) share is
reported. Because of its significance, earnings per share are reported on the income
statement just below the amount of the net profit. It is calculated by dividing the net profit
by the number of shares issued.

An entity should also disclose the dividends per share declared or proposed for the period
covered by the financial statements.

? THINK POINT 3
Do you think that dividends declared for the financial period should be reflected in the
income statement? Explain.

2.

CASH FLOW STATEMENT
The cash flow statement (or statement of cash flows), is a relatively new financial
statement, that developed to fulfil the needs of the users of financial statements. This is
largely due to the fact that the income statement is based on the accrual basis and does not
show the cash flows from operating activities and also does not provide valuable
information relating to cash flows from investing and financing activities (except for some
related expenses and income). The main purpose of a cash flow statement is to provide
information about the cash receipts and cash payments of an entity for a specific period.
The statement provides reasons why cash and cash equivalents changed during the period
by reflecting the net cash utilised or generated by operating activities, investing activities
and financing activities.

Having an understanding of a companys cash flows and the reasons for the cash flows are
important to investors, managers, and other decision-makers. To be able to grow, a
company must generate adequate cash flows to pay its bills, repay its debt, and provide an
adequate return to its owners. Information obtained from a cash flow statement is used for
evaluating past performance and future prospects.

2.1

Operating activities
The cash flows from operating activities are derived from the main revenue-generating
activities of the entity. They are cash flows that result from transactions reflected in the
income statement. However, due to the determination of income and expenses according to
the accrual basis, certain non-cash items are also included and they need to be excluded to
determine the cash resulting from operating activities.



? THINK POINT 4
Of what use is the cash from operating activities to the users of financial statements?

The cash flow statement can be presented using two different formats. These formats only
differ in the manner in which cash generated from operations is disclosed on the face of
the statement. The remaining parts of the cash flow statement are identical for both formats.

The first format called the direct method prescribes that the operating cash flows be
disclosed according to the entitys major classes of gross cash receipts and gross cash
payments. The following is an illustration of the disclosure on the face of the cash flow
statement of cash generated from operations using this method.

Exhibit 4-6
Direct method

Cash received from customers
Cash paid to suppliers and employees
R
2 000 000
(950 000)
Cash generated from operations

1 050 000

The second format is called the indirect method. Using this method, the cash flows from
operating activities are calculated by adjusting profit before interest in order to determine
cash generated from operations. The adjustments involve the following:
* items relating to investing and financing decisions e.g. loss on sale of equipment
* non-cash flow adjustments e.g. depreciation
* the effect of using the accrual basis (changes in working capital).

The following is an illustration of the disclosure on the face of the cash flow statement of
cash generated from operations using the indirect method.



Exhibit 4-7
Indirect method

Profit before interest and tax i.e. operating profit
Adjustments to convert to cash from operations
R
1 450 000

Non-cash flow adjustments 100 000
Add: Depreciation
Add: Foreign exchange loss
60 000
40 000

Profit before working capital changes
Working capital changes

(500 000)

Increase in inventory
Increase in receivables
Increase in payables
(400 000)
(200 000)
100 000

Cash generated from operations 1 050 000

When the direct method is used, the reconciliation of operating profit in the income
statement to cash flows from operations is not disclosed in the cash flow statement.
However, it is recommended that the reconciliation between net profit before tax and
interest and cash generated from operations be shown as a note to the cash flow statement.
This reconciliation will allow the user to assess the ability of the enterprise to convert
operating profit into cash. Exhibit 4-7 indicates that when the indirect method is used,
information relating to the reconciliation of operating profit to cash flows from operations
is presented on the face of the cash flow statement.

2.2

Investing activities
This category of the cash flow statement provides details about specific expenditures made
to generate future income and outflows. It relates mainly to the purchase and sale of non-
current assets. Separate disclosure of investing activities to expand operations is
recommended. Examples of cash flows from investing activities include:
payments to acquire non-current assets;
receipts from sale of non-current assets;
payments to acquire other entities and other equity or debt instruments;
receipts from sale of interests in other entities, and sale of other equity or debt instruments;
loans made to other parties or receipts from the repayment of such loans.


The following is an example of how cash flow from investing activities would appear on
the face of the cash flow statement:

Exhibit 4-8

Cash flow from investing activities
R
(50 000)

Additions to plant and equipment
Proceeds from sale of land and buildings
(200 000)
150 000

2.3

Financing activities
Cash flows from financing activities provide information relating to cash flows to and from
providers of capital. This is useful to investors who wish to predict any future claims on the
cash of the entity. Examples of cash flows from financing activities include:
proceeds from the issue of shares and other equity instruments;
proceeds from loans, bonds and issue of debentures;
repayments of amounts borrowed.

The following is an example of the disclosure of cash flow from financing activities on the
face of the cash flow statement:

Exhibit 4-9

Cash flow from financing activities
R
250 000

Long-term borrowings redeemed
Proceeds from shares issued
(50 000)
300 000


2.4

Interpretation of cash flow patterns
Ingram et al (2005: 190) provide a summary (exhibit 4-10) of common cash flow
combinations together with an indication of how well a company may be performing.

Exhibit 4-10
Operating
Cash flows
Investing
Cash flows
Financing
Cash flows

Normal interpretation

+

+
The company is prosperous and growing.
Financing cash flow is used to take advantage
of growth opportunities.

+

+
The company is facing serious financial
problems. It is selling assets and using
financing activities to meet current cash needs.

+

+ or

The company is prosperous but may not have a
lot of good growth opportunities. It is using
operating cash to pay off debt and pay
shareholders.

+ or

+

The company may be facing a current cash
flow problem. It is selling assets to supplement
current cash flows to cover its financing needs.
This is especially a problem if the company is
short of cash to repay debt.

The amount of the increase or decrease in an entitys cash balance is usually not of major
importance. Quite often the change is small. A small increase or decrease in cash does not
signify financial problems or strengths. A net decrease in cash must not be interpreted as
being a huge financial problem for an entity. The focus should rather be on the changes in
operating, investing and financing cash flows.


3.
3.1

3.2

3.3

3.4
3.5
Of what significance is the Income statement to managers, shareholders, potential investors
and others?
Explain the implications of the matching principle on the preparation of the income
statement.
In an income statement that is prepared in accordance with accounting principles, what
does a sales figure of R800 000 mean?
Explain the significance of the gross profit ratio to management.
JB Enterprises expects to have a gross profit ratio of 60% for the current financial year.
Opening inventory amounted to R38 000. Net sales and net purchases for the year are
R200 000 and R126 000 respectively. The entire closing inventory was destroyed by fire.
Calculate the estimated value of closing inventory.
3.6 The cost of a kilogram pack of washing powder is R16 to Nino Ltd. What should the
selling price be if a 60% gross profit ratio is desired?
3.7 What may be the consequence of the interest rate on borrowed funds being greater than the
return on assets?
3.8 Study the income statement of Rivonia Ltd for the years ended 30 June 20.6 and 20.5 and
answer the questions that follow:
Income statement for the years ended 30 June 20.6 and 20.5.

Net sales
Cost of sales
20.6 (R)
800 000
450 000
20.5 (R)
680 000
432 500

Gross profit 350 000 247 500
Selling, general and administrative expenses 125 000 106 250
Income from operations 225 000 141 250
Other income (expenses)
Interest expense
Other income
Loss on disposal of asset

16 000
11 000
5 000

14 000
12 000
-

Profit before tax 215 000 139 250
Income tax 95 000 70 000
Net Profit 120 000 69 250
Earnings per share ? R0,14



3.8.1

Questions
Based on the mark-up used to determine the selling price, management expected a gross
profit of R400 000 for 20.6. What are the possible reasons for the gross profit being lower
than expected?
3.8.2 Has the gross profit ratio improved from the financial year ending 20.5 to 20.6? Explain
how this could have happened.
3.8.3 Name some specific expenses that could be included as Selling, general and administrative
expenses.
3.8.4 Could there have been any movements in the non-current liabilities? Explain.
3.8.5 If the carrying value of the asset sold was R13 000, calculate the selling price.
3.8.6 The interest rate on loans was 16% whilst the return on assets was 24%. How would
shareholders interpret this?
3.8.7 Has the earnings per share for the financial year ended 20.6 improved over the previous
financial year? How do you think shareholders will feel about this? (Note the number of
shares issued was 500 000.)
3.8.8 Comment on the financial result of the company for 20.6.

3.9
3.9.1
3.9.2
In a cash flow statement, how would you interpret the following:
a positive cash flow from operating activities?
a negative cash flow from operating activities?

3.10

Users of financial statements usually compare the cash used for investing activities with the
cash provided by operating activities? Explain why.

3.11

Answer the following questions based on information gleaned from a cash flow statement
of a company.
3.11.1 Cash flows from operating activities are decreasing even though profits are increasing.
How would you explain this? What are possible consequences?
3.11.2 Of what significance are the details of an entitys investing activities to an investor?
3.11.3 How would you interpret a combination of positive net cash flows from operating activities
and negative cash flows for investing activities?
3.11.4 A company generates more cash from operating activities than it can use for investing
activities. What would the company probably do with the cash? What does this say about
the performance and prospects of the company?
3.11.5 Cash inflow from financing activities may be a positive sign or a negative sign depending
on how the funds were utilised. Discuss this statement.

SOLUTIONS

? THINK POINT 1
The supplier cannot recognise the revenue of the sale until the equipment has been
manufactured and delivered to the customer. Since the customer has already paid, the
amount received will be reflected as a liability.

? THINK POINT 2
Certain items are treated differently in terms of Generally Accepted Accounting Practice
and the Income Tax Act. As a result the net profit (before tax) will differ from the taxable
income. Examples of such differences include the following:
The companys accounting depreciation expenses may differ from the tax depreciation
(called wear-and-tear allowances) allowed by the Income Tax Act.
Certain expenses may not be allowed as deductions for income tax purposes e.g. traffic
fines.
Certain kinds of income are excluded from taxable income as they are exempt e.g. SA
source dividends received.

? THINK POINT 3
No. A dividend does not reflect the performance of an entity. It is distributed as a result of
the performance of an entity. The income statement reflects the profit of a company where
profit is income less expenses. The definition of an expense excludes the result of
transactions with shareholders. A dividend results from a distribution to shareholders and is
therefore not an expense.



? THINK POINT 4
Cash from operating activities is an important indicator of the extent to which an entity was
able to obtain sufficient cash from its day-to-day operations to (without having to raise
additional finance):
* repay its loans.
* pay dividends.
* make new investments.

Trends that emerge from cash from operating activities are useful in predicting future
operating cash flows.

3.1

They would be interested in the financial results of the entity. In particular they may want
to know amongst other things:
* The amount of profit or loss that was made.
* Whether the profit realised is a satisfactory return on the capital invested.
* Whether sales are increasing relative to cost of sales and other operating expenses.
* Whether the entity is exercising effective control over expenses.
* The impact of the financial result on the financial position of the entity.
* How to evaluate the stewardship of the directors.

3.2 * The objective of financial statements is to report transactions to users as and when they
occur.
* Revenue earned and costs incurred are thus reflected in the income statement of the
period in which they relate irrespective of the period of receipt or payment.
* It will be inappropriate to report profit as the difference between cash received and cash
paid during a period because some trading and commercial activities would be excluded
since many transactions are based on credit.
* Applying the matching principle will result in the development of financial statements
that report the entitys correct financial position to the stakeholders.


3.3

The sales figure does not represent cash received from sales. Rather it represents an
increase in the assets of the entity from the sale of merchandise to customers. The sales
figure thus represents the total assets that are expected to be received from the transactions
irrespective of when the cash was received. Note that the sales figure would have already
been adjusted (decreased) to take into account sales returns and allowances and cash
discounts to customers.

3.4 This ratio is of significance to managers in the following ways:
Since the ratio measures the amount of each Rand of sales that is available to cover
operating expenses and profit, one of its main uses is to determine whether the entity is
operating at a level of sales that will lead to profitability in the current period. Managers
will know from past experience the gross profit ratio that is required to be profitable.
The gross profit ratio can be used to estimate the cost of sales and closing inventory for
periods in which physical stocktaking was not done. An estimate of inventory destroyed by
fire, floods or other natural disasters can be made.
The gross profit ratio is also used to set selling prices. If the gross profit ratio needed to
achieve profitability at a given level of sales, the selling price can be determined by
dividing the cost of the item by the complement of the gross profit ratio.

3.5

Sales
Cost of sales
Cost of opening inventory
Net purchases
R

38 000
126 000
R
200 000
(80 000)

100%
40% of R200 000

Cost of goods available for sale
Cost of closing inventory
164 000
*(84 000)

*R164 000 R80 000
Gross profit 120 000 60% of R200 000

* Note: The expected cost of closing inventory is calculated last.


3.6

Selling price = R16
40%
= R40

3.7

If the return on assets is less than the interest rate on borrowed funds, this will add risk to
the entity because if the entity does not earn enough to pay the interest on the debt, the
debt-holders can eventually force the entity into bankruptcy.

3.8
3.8.1

Some merchandise may have been sold below the normal selling price.
Monthly or seasonal sales may have been held.
Some merchandise may have been incorrectly priced.

3.8.2
Gross profit ratio
20.6

= Gross profit X 100
Net sales

= R350 000 X 100
R800 000

= 43,75%
20.5

= Gross profit X 100
Net sales

= R247 500 X 100
R680 000

= 36,40%

Yes. The ratio has improved from 36,40 % to 43,75%. This could be attributed to one or
more of the following:
Merchandise may have been procured at a lower price than the previous financial year.
The business may have not been liberal in granting cash discounts to customers.
Fewer sales may have been held.

3.8.3 Salaries, advertising, depreciation, rent expense, insurance, stationery, repairs and
maintenance etc.

3.8.4

Yes. The increase in interest expense indicates that non-current liabilities may have
increased.

3.8.5 Selling price = R13 000 R 5 000 = R8 000

3.8.6

Since the company borrowed money at an interest cost of 16% and was able to use to earn a
return higher than 16%, the shareholders will have a greater return on their investment than
if they provided all of the funds themselves. In other words, the use of borrowed money
enhanced the return to owners.

3.8.7

Earnings per share =
20.6

Net profit

=

=
No. of shares issued

R120 000
500 000

R0,24

Yes. Earnings per share increased by R0,10 per share. Shareholders should be happy with
this increase as it represents an improvement in the financial performance of the company.
Higher earnings per share means that they can expect a greater dividend per share.
3.8.8

The financial result of the company, as evidenced by the net profit, has improved since
20.5. This is further substantiated by the increase in the earnings per share. This could be
largely attributed to the 17,65% increase in net sales as well as the attainment of a higher
gross profit ratio.

3.9

An entity that has a positive cash flow from operating activities has sufficient funds to
finance its day-to-day activities and may even have sufficient cash to finance investing
activities like the purchase of property, plant and equipment.

A negative cash flow from operating activities usually forces the entity to obtain outside
funding to finance its day-to-day activities as well as its investing activities. A negative
cash flow from operating activities may be expected initially from an entity that has just
started but it is a sign of possible financial weakness to an established entity.

3.10

If the cash from operating activities is greater than the cash used for investing activities,
this indicates that the entity is generating cash it requires to finance its expansion. If the
cash from operating activities is less than the cash used for investing activities, this
indicates that the entity had to obtain cash from financing activities or use cash
accumulated from the previous year. This may not be a serious problem because investment

requirements in one year may be unusually high. However, if cash from operating activities
is less than the cash needed for investing activities year after year, and the difference is
obtained from financing activities then the ability to acquire funds from financing activities
will be brought into question. Creditors will refuse to lend money to an entity that cannot
generate operating cash flows to ensure the repayment of debt.

3.11
3.11.1

It may be that accounts receivable and/or inventories are increasing at a higher rate than
sales.
This is a sign that the business may experience liquidity problems (inability to pay short-
term debts) that may not be detected by liquidity ratios. The inability of the entity to collect
its accounts receivable and/or sell its inventory may artificially increase current assets
thereby creating a false impression that the entity would be able to pay off its short term
obligations.

3.11.2

The details of an entitys investing activities may give a good idea of its growth strategy.
Users will be able to determine whether the entity is acquiring capacity by investing in
more property, plant and equipment or by purchasing other entities. If property, plant and
equipment is sold, users will want to know the reasons for and consequences of such a sale.

3.11.3

It is a sign of good performance and growth. The excess cash from operating activities is
used for expansion through the purchase of additional assets. The value of a company
increases as it grows. As the company expands by purchasing additional assets, it will be
able to produce and sell more products, which in turn will result in greater profitability and
increased operating cash flows.

3.11.4

It will probably use the cash to repay debt or make payments to shareholders. If the
payments are large, this may indicate that the company is performing well but does not
have a lot of good investing opportunities.

3.11.5

It is a positive sign if the company is using the cash in investing activities i.e. buying more
assets. It is a negative sign if the cash is used for operating activities.

TOPIC 5
FINANCIAL ANALYSIS

LEARNING OUTCOMES
explain why it is important to analyse financial statements.
calculate and interpret ratios from managements point of view.
calculate and interpret ratios from owners point of view.
calculate and interpret ratios from the point of view of creditors and lenders.

CONTENTS
1. Introduction
2. Ratio analysis
3. Ratio analysis: Managements point of view
4. Ratio analysis: Owners point of view
5. Ratio analysis: Lenders and creditors point of view
6. Self-assessment activities
7. Solutions


READING
Prescribed
9
th

Recommended
Helfert, E.A. (2003) Techniques of Financial Analysis. 11
th
Edition. New York:
McGraw-Hill/Irwin. pp.107-144
Meredith, G. and Williams, B. (2005) Managing finance: Essential Skills for Managers.
1
st
Edition. North Ryde: McDraw-Hill. pp.75-93


1. INTRODUCTION
According to Helfert (2003:107) when one wishes to assess the performance of a
business, one looks for ways to measure the financial and economic consequences of
past management decisions that shaped investments, operations, and financing over
time. One needs to know whether resources were used effectively, whether
profitability expectations were achieved or even exceeded, and whether financing
choices were made prudently.

In this topic we will analyse business performance based on information contained in
financial statements. Meredith and Williams (2005:76) state that the analysis of
financial statements is important in order to:
explain and understand the reasons for levels of performance of sales, control of
expenses, profits, funds, and investment in general.
identify trends in performance and owner investment over time.
identify the position of the enterprise in an industry in order to identify strengths,
weaknesses, opportunities, and threats.
understand past performance in order to plan for the future.
assist managers and owners to make the best use of available resources.

2. RATIO ANALYSIS
A ratio may be defined as the relationship between two sets of values obtained from
financial statements. Ratios provide a means to summarise complex accounting
information into a small number of key indicators. They make figures more easily
comparable.

Our discussion will focus on three major viewpoints of financial performance
analysis viz.:
Managers
Owners
Lenders and creditors

Helfert (2003:110) indicates the main performance areas of interest to management,
owners, and lenders in Figure 1-1, together with the most common ratios:


Figure 1-1

MANAGEMENT

OWNERS
LENDERS AND
CREDITORS
Operational analysis Profitability Liquidity
Gross margin Return on equity Current ratio
Operating margin Earnings per share Acid test ratio
Profit margin
Resource management Disposition of earnings Financial leverage
Inventory turnover Dividend per share Debt to assets
Debtors collection period Earnings retention Debt to equity
Creditors payment period
Turnover to net assets
Profitability Market indicators Debt service
Return on assets Price/Earnings ratio Interest coverage
Return on capital employed

Well now follow the sequence shown in Figure 1-1 and discuss each sub-grouping
within the three broad viewpoints. For the purposes of illustration we will use
information from Figure 1-2 and Figure 1-3 adapted from Helfert (2003:111) that
represent the simplified Income Statement and Balance Sheet respectively of Reunion
Limited. We will also follow his discussion of the ratios.


Figure 1-2
Reunion Limited
Income Statements for the year ended 31 December 20.9 and 20.8
20.9 20.8
Sales (all credit) 3 344 800 3 149 600
Cost of sales (all credit purchases) (1 757 400) (1 625 200)
Gross profit 1 587 400 1 524 400
Operating expenses: (975 800) (933 200)
Selling, general and administrative
Other expenses
792 600
183 200
742 400
190 800
Operating profit 611 600 591 200
Other income: 5 400 6 600
Interest income 5 400 6 600
Profit before interest 617 000 597 800
Interest expense (103 584) (121 216)
Profit before tax 513 416 476 584
Tax (154 026) (142 974)
Net profit after tax 359 390 333 610

Figure 1-3
Reunion Limited
Balance Sheets the year ended 31 December 20.9 and 20.8
Assets 20.9 20.8
Non-current assets 1 628 600 1 566 000
Current assets: 1 275 800 1 213 200
Inventories
Accounts receivable
462 400
578 200
235 200
406 000
555 600
251 600
Total assets 2 904 400 2 779 200

20.9 20.8

Owners equity and liabilities
Owners equity 1 306 200 1 257 800
Ordinary share capital (Par value R1 each) 1 200 000 1 200 000
Retained earnings 106 200 57 800
Non-current liabilities (16% p.a.) 647 400 757 600
Current liabilities 950 800 763 800
Accounts payable 216 200 201 600
Other current liabilities 734 600 562 200
Total owners equity and liabilities 2 904 400 2 779 200

3. RATIO ANALYSIS: MANAGEMENTS POINT OF VIEW
Helfert (2003:109) maintains that management has a dual interest in the analysis of
financial performance viz.:
To evaluate the efficiency and profitability of operations.
To assess how effective the resources of the enterprise are being used.

Evaluating the operations of an enterprise is largely done by an analysis of the
income statement whilst the effectiveness of resources is usually measured by a
review of both the income statement and balance sheet.

3.1 Operational analysis
An evaluation of operational effectiveness may be performed by a percentage analysis
of the income statement. The use of sales as a common base permits a ready
comparison of key costs and expenses from period to period, and against competitor
and industry databases.

3.1.1 Gross margin
Gross margin (also called gross profit margin) is one of the most common ratios in
operational analysis. It reflects the mark-up or value added over cost. It shows
operational effectiveness before expenses are considered. It is calculated by
expressing the gross profit as a percentage of sales:

Gross margin = Gross profit X 100
Sales 1

The gross margin ratio indicates the profit of the firm relative to sales after deducting
the cost of sales. Apart from measuring the efficiency of the enterprises operations,
it also indicates how products are priced. In the case of Reunion Limited gross
margin is as follows:

20.9 20.8
Gross margin = Gross profit X 100 Gross margin = Gross profit X 100
Sales 1 Sales 1
= R1 587 400 X 100 = R1 524 400 X 100
R3 344 800 1 R3 149 600 1
= 47.46% = 48.40%

A gross margin decline of 0.94% occurred from the previous year. A lower gross
margin may be the result of a number of factors:
The company may have consciously reduced margins in order to increase sales.
Margins may have been reduced to maintain sales levels in the face of increased
competition.
Price increases may have increased sales but the company may not have been able to
pass all the inflationary increases in the cost of sales to customers.
The sales mix may have been unfavourable i.e. a greater number of lower profit-
bearing products were sold.

THINK POINT 1
One should assume that a fall in gross margin means that a company is becoming less
profitable and an increase in gross margin means that a company is becoming more
profitable. Do you agree? Explain.

3.1.2 Operating margin
This ratio shows the operational effectiveness of a company before the cost of
financing (interest expense), other miscellaneous income (e.g. interest income) and
income tax.


Operating margin is calculated by expressing the operating profit as a percentage of
sales:
Operating margin = Operating profit X 100
Sales 1

The operating margin of Reunion Limited is as follows:

20.9 20.8
Operating margin Operating margin
= Operating profit X 100 = Operating profit X 100
Sales 1 Sales 1
= R611 600 X 100 = R591 200 X 100
R3 344 800 1 R3 149 600 1
= 18.29% = 18.77%

A small decline of 0.48% from 20.8 is observed. Operating expenses thus increased
at a higher rate than the increase in sales.

3.1.3 Profit margin
This ratio pertains to the relationship of net profit after taxes to sales and is indicative
of managements ability to operate the enterprise profitably. This is the margin on
sales that is potentially available for distribution to shareholders. To be successful an
enterprise must not only recover the cost of the merchandise, the operating expenses,
and the cost of borrowed funds but also there must also be reasonable compensation
to the owners for putting their capital at risk. The profit margin ratio is important to
operating managers since it reflects an enterprises pricing strategy and its ability to
control operating costs.

Profit margin is calculated by expressing the net profit after taxes as a percentage of
sales:

Profit margin = Net profit after tax X 100
Sales 1


The profit margin of Reunion Limited is as follows:

20.9 20.8
Profit margin Profit margin
= Net profit after tax X 100 = Net profit after tax X 100
Sales 1 Sales 1
= R359 390 X 100 = R333 610 X 100
R3 344 800 1 R3 149 600 1
= 10.74% = 10.59%

The ratio shows that the earnings available to shareholders were 10.74% of sales. A
small improvement of 0.15% from 20.8 is also noted. Net profit margin is
significantly lower than the gross margin and is probably due to the high operating
expenses.

3.2 Resource management
Resource management concerns the effectiveness with which management has
employed the assets entrusted to it by the owners of the enterprise. We will focus on
the rate at which inventory is sold, the time taken by debtors to pay accounts, the time
taken to settle creditors accounts and turnover to net assets..

3.2.1 Inventory turnover
In evaluating the effectiveness of an enterprises inventory management, it is
common to use the number of times inventory has turned over during the period of
analysis. The higher the turnover rate the better, since low inventories usually
suggest a minimal risk of non-saleable merchandise and also indicates efficient use of
capital. Inventory turnover is calculated as follows:

I nventory turnover = Cost of sales
Average inventory

Average inventories refer to the average of the beginning and ending inventories.
The inventory turnover of Reunion Limited is calculated as follows (Note:
Inventories for 20.7 amounted to R449 360.):

20.9 20.8
I nventory turnover I nventory turnover
= Cost of sales = Cost of sales
Average inventory Average inventory
= R1 757 400 = R1 625 200
R434 200 R427 680
= 4.05 times = 3.80 times

Note: Average inventory is calculated as follows:
20.9 20.8
= R462 400 + R406 000 = R406 000 + R449 360
2 2
= R434 200 = R427 680

The inventory turnover of Reunion Limited shows an increase from 3.80 times to
4.05 times per annum, indicating an improvement in efficiency. The analyst must
check that the improvement is not a result of dumping inventory on dealers etc. The
inventory turnover of 4.05 times for 20.9 implies that merchandise remains in
inventory for an average of 90 days (365 days 4.05 times) before being sold.

THINK POINT 2
What do you think are the implications for an enterprise if:
inventory turnover is low?
inventory turnover is high?

3.2.2 Debtor collection period
This ratio is useful in assessing the effectiveness of the credit administration of a
company. It ratio tells us how long, on average, trade debtors meet their obligations
to pay following the sale on credit. It highlights the enterprises management of
debtors (or accounts receivable). One would want to know whether the accounts
receivable that are outstanding at the end of the period closely approximate the
amount of credit sales one would expect to remain outstanding under prevailing
credit terms.

This is done as follows:
Debtor collection period = Accounts receivable X 365
Credit sales

20.9 20.8
Debtor collection period Debtor collection period
= Accounts receivable X 365 = Accounts receivable X 365
Credit sales Credit sales
= R578 200 X 365 = R555 600 X 365
R3 344 800 R3 149 600
= 63.10 days = 64.39 days

The debtor collection period may be interpreted in two ways. One can say that
Reunion Limited has an average of 63.10 days worth of credit sales tied up in
accounts receivable, or one can say that the average time lag between sale and receipt
of cash from the sale is 63.10 days. This collection period allows us to compare it
with the terms of sale. Thus if Reunion Limited sells on 30 day terms, the collection
period is very unsatisfactory. It could mean that some customers had difficulty
paying, or were abusing their credit privileges, or that some sales were made on
extended terms.

An increasing ratio indicates that a company is experiencing difficulties in collecting
debts. This may be an early warning sign of large bad debts.

3.2.3 Creditor payment period
This ratio tells us how long, on average, an enterprise takes to pay for goods bought
following the purchase on credit. It is used to evaluate an enterprises performance
with regard to the management of accounts payable (creditors). The number of days
of accounts payable (or creditor payment period) is compared to the credit terms
under which the enterprise makes purchases. Significant deviations from this norm
can be detected. Optimal management of accounts payable requires making payment
within the stated terms and no earlier except taking advantage of discounts whenever
offered for early payment. The ratio could thus indicate whether the company is
taking more time than usual to pay or if it is having difficulty in paying.

It will also indicate whether the company is taking full advantage of credit facilities
given to it.

Creditor payment period may be calculated as follows:

Creditor payment period = Accounts payable X 365
Credit purchases

20.9 20.8
Creditor payment period Creditor payment period
= Accounts payable X 365 = Accounts payable X 365
Credit purchases Credit purchases
= R216 200 X 365 = R201 600 X 365
R1 813 800 R1 581 840
= 43.51 days = 46.52 days

Note: Credit purchases are calculated as follows:
20.9 20.8
Cost of sales 1 757 400 1 625 200
Add: Closing inventory 462 400 406 000
2 219 800 2 031 200
Less opening inventory (406 000) (449 360)
Purchases (all credit) 1 813 800 1 581 840

Reunion Limited is probably allowed credit terms of between 30 days and 60 days by
creditors.

3.2.4 Turnover to net assets
This ratio is a measure of the sales rands generated by each rand of net assets.
Conversely it indicates the size of the net asset commitment required to support a
particular level of sales. Using net assets eliminates current liabilities from the total
assets. The assumption is that current liabilities are available to the company as a
matter of course. Thus the amount of assets employed in the business is effectively
reduced through these ongoing operational credit relationships.

Turnover to net assets is calculated simply as follows :

Turnover to net assets = Sales
Net assets

Turnover to net assets of Reunion Limited is calculated as follows:

20.9 20.8
Turnover to net assets Turnover to net assets
Sales Sales
Net assets Net assets
= R3 344 800 = R3 149 600
R2 904 400 R950 800 R2 779 200 R763 800
= R3 344 800 = R3 149 600
R1 953 600 R2 015 400
= 1.71:1 = 1.56:1

The sales generated by each rand of net assets have increased from R1.56 to R1.71.
This also indicates that the net assets required to support a level of sales have
decreased. The reasons for the improvement must be investigated.

3.3 Profitability
Here we examine how effectively management has employed the total assets and
capital as recorded in the balance sheet. This is evaluated by relating net profit,
defined in a variety of ways, to resources used to generate the profit. A satisfactory
return is one that:
exceeds the inflation rate.
is higher than alternative investments e.g. fixed deposits.
is higher than the cost of borrowing funds.

3.3.1 Return on assets (Operating profit on total assets)
Return on assets (ROA) measures the efficiency with which an enterprise allocates
and manages its resources i.e. whether the assets of the company are adequately and
effectively used.

A company that does not have a good return on total assets cannot generate a good
return on equity. ROA is calculated as follows:

Return on assets = Operating profit X 100
Total assets 1

Return on assets of Reunion Limited is calculated as follows:

20.9 20.8
Return on assets Return on assets
Total assets 1 Total assets 1
= R611 600 X 100 = R591 200 X 100
R2 904 400 1 R2 779 200 1
= 21.06% = 21.27%

Reunion Limited experienced a slight decline in profitability. It needs to compare
this return to other similar companies, the inflation rate, return on alternative
investments, and interest rate on borrowed capital to determine whether it is satisfied
with the return.

3.3.2 Return on capital employed
This ratio enables the analyst to determine whether the return earned is in excess of
what could be earned elsewhere. The return must, at the least, be greater than the
prevailing rates of interest and the weighted average cost of borrowings. This ratio is
an important comparison to the cost of the companys capital. The calculation is as
follows:

Return on capital employed = Operating profit X 100
Capital employed 1

Capital employed consists of owners equity and non-current liabilities. Return on
capital employed for Reunion Limited is as follows:


20.9
= Operating profit X 100
Capital employed 1
= R611 600 X 100
R1 953 600 1
= 31.31%

20.8
Capital employed 1
= R591 200 X 100
R2 015 400 1
= 29.33%

The return on capital employed has improved. Since the return (31.31%) is greater
than the prevailing rate of interest (16%), the return is considered to be satisfactory.

4. RATIO ANALYSIS: OWNERS POINT OF VIEW
Owners are mainly interested in the profitability of the company. In this context
profitability refers to the returns earned through the efforts of management on the
funds invested by the owners. The owners would also be interested on the disposition
of earnings i.e. how much is paid out to them versus how much is reinvested in the
company. Lastly, they are concerned about the effect of the business results on the
market value of their shares.

4.1 Profitability
Financial analysts keep a close watch on the relationship between the profits earned
to the shareholders stated investment. Several key measures that express the
companys performance in relation to the owners stake may be used.


The return on equity measures the profitability of the total ownership investment
while the earnings per share measures the proportional participation of each unit of
investment in corporate earnings for the period.

4.1.1 Return on equity (ROE)
Return on equity measures the rate of return on shareholders investment. It enables
one to check whether the return made on an investment is better than alternatives
available. It is calculated by expressing (as a percentage) the net profit after tax on
the average owners (shareholders) equity:

Return on equity = Profit after tax X 100
Owners equity 1

Return on equity for Reunion Limited is calculated as follows:

20.9
Return on equity
= Profit after tax X 100
Owners equity 1
= R359 390 X 100
R1 306 200 1
= 27.51%

20.8
Return on equity
Owners equity 1
= R333 610 X 100
R1 257 800 1
= 26.52%


The return on equity has improved slightly. If alternative investments carrying a
similar risk yield a return in excess of this (27.51%), this would indicate that the
companys profitability is low. However, it is unlikely to be the case here.

A good return on equity fuels investment interest from prospective investors. It
increases share prices and makes it easier for the company to borrow money.

4.1.2 Earnings per share (EPS)
Earnings per share is often considered to be an indicator of profitability. It is a
measure that both management and shareholders pay a great deal of attention to. It is
widely used to value ordinary shares and is often the basis for setting specific
corporate objectives and goals as part of strategic planning. The ratio simply
involves dividing net profit after tax by the number of ordinary shares in issue:

Earnings per share = Net profit after tax
Number of ordinary shares issued

Earnings per share for Reunion Limited is calculated as follows:

20.9 20.8
Earnings per share Earnings per share
= Net profit after tax Net profit after tax
Number of ordinary shares issued Number of ordinary shares issued
= R359 390 X 100 = R333 610 X 100
1 200 000 1 200 000
= 29.95 cents = 27.80 cents

The earnings per share has increased by 2.15 cents per share.

4.2 Disposition of earnings
The periodic separation of the net profit after tax (earnings) into dividends paid and
earnings retained is closely monitored by shareholders and the financial community
because the retained residual builds up the owners equity and is a source of funds for
managements use.

Earnings may thus be either reinvested in the company to fund further growth or paid
out in part or full as dividends.

4.2.1 Dividend per share (DPS)
Dividends are usually declared on a per share basis by the companys board of
directors. The board of directors usually has a dividend policy in place. Because the
value of ordinary shares is partly influenced by dividends paid and anticipated, the
board has to deal with this periodic decision very carefully. DPS is calculated by
dividing the dividends for the year by the number of ordinary shares issued:

Dividend per share = Dividends for the year

If the dividends of Reunion Limited for 20.9 and 20.8 were R220 000 and
R200 000 respectively, then the dividend per share is calculated as follows:

20.9 20.8
Dividend per share Dividend per share
= Dividends for the year Dividends for the year
= R220 000 X 100 = R200 000 X 100
1 200 000 1 200 000
= 18.33 cents = 16.67 cents

The dividend per share has risen by 1.66 cents per share, most likely due to the
increase in earnings per share.

4.2.2 Earnings retention
This ratio gives an indication of the amount of profit put back into the company and
is a useful ratio when determining the long-term prospects of a company. The
alternative to doing this ratio is to calculate the dividend payout ratio which is
calculated by dividing the dividend per share by the earnings per share.


Since most companies have a policy of paying dividends that are a relatively constant
proportion of earnings (e.g. 30 to 40%), these ratios permit shareholders to project
dividends from an assessment of the firms earnings prospects. Earnings retention
ratio is calculated as follows:

Earnings retention ratio = Earnings per share Dividend per share X 100
Earnings per share

OR
Earnings retention ratio = Retained earnings for the year X 100
Profit due to ordinary shareholders

(Retained earnings = Profit due to ordinary shareholders Ordinary dividend for the year)

The earnings retention ratio for Reunion Limited is calculated as follows:

20.9
Earnings retention ratio
= Earnings per share Dividend per share X 100
Earnings per share 1
= 29.95 cents 18.33 cents X 100
29.95 cents 1
= 11.62 cents X 100
29.95 cents 1
= 38.80%


OR
20.9
= Retained earnings for the year X 100
Profit due to ordinary shareholders 1
= R359 390 R220 000 X 100
R359 390 1
= R139 390 X 100
R359 390 1
= 38.79%

20.8
= 27.80 cents 16.67 cents X 100
27.80 cents 1
= 11.13 cents X 100
27.80 cents 1
= 40.04%
OR
20.8
= R333 610 R200 000 X 100
R333 610 1
= R133 610 X 100
R333 610 1
= 40.05%


It appears that the company retains about 40% of the profit. This implies that the
dividend payout ratio is about 60% which is a fairly high payout and this can cause
problems with liquidity in difficult years. Also, adequate funds may not be available
for expansion when the need arises.

4.3 Market indicators
Here we will discuss one of the common indicators of stock market values viz.
price/earnings ratio.

4.3.1 Price/Earnings (P/E) ratio
According to Marshall et al (2011: 421) this ratio is one of the most important
measures used by investors and managers to evaluate the market price of a
companys ordinary shares. It is also used to indicate how the stock market is
judging the companys earnings performance and prospects. This is one reason why
the EPS is reported prominently on the face of the income statement. Earnings
multiple is another term for price/earnings ratio. This term merely reflects the fact
that the market price of a share is equal to the EPS multiplied by the P/E ratio.
Price/earnings ratio is calculated as follows:

Price/Earnings ratio = Market price per share
Earnings per share

The Price/Earnings ratio for Reunion Limited (market price per share for 20.9 and
20.8 was 130 cents and 120 cents respectively) is calculated as follows:

20.9 20.8
Price/Earnings ratio Price/Earnings ratio
= Market price per share = Market price per share
= 130 cents = 120 cents
29.95 cents 27.80 cents


The ratio shows that investors are willing to pay approximately 4.34 times earnings
for the shares. This ratio needs to be compared to the average P/E ratio of similar
companies. An above-average P/E ratio indicates that the market price is high
relative to the companys current earnings, possibly because investors anticipate
favourable future developments such as increased EPS or higher DPS. Low P/E
ratios usually indicate poor earnings expectations.

5. RATIO ANALYSIS: LENDERS AND CREDITORS POINT OF VIEW
Lenders and creditors are interested in funding the needs of a successful enterprise
that will perform according to expectations. However, they have to also consider the
negative consequences of default and liquidation. Lenders and creditors have to
carefully assess the risk involved in recovering the funds extended. They therefore
have to look for a margin of safety in the assets held by the enterprise. Several ratios
are used to evaluate this protection by testing the liquidity of the enterprise. Another
set of ratios tests the leverage of the enterprise in order to weigh the position of
lenders versus owners. Lastly, there are coverage ratios that relate to the enterprises
ability to provide debt service from the funds generated by operations.

5.1 Liquidity
Liquidity ratios measure the ability of an enterprise to meet its short-term obligations.
They focus on the liquid assets of the enterprise i.e. current assets that can readily be
converted into cash on the assumption that they form a cushion against default. The
most commonly used liquidity ratios are the current ratio and acid test ratio.

5.1.1 Current ratio
The current ratio shows the relationship between current assets and current liabilities
and is an attempt to show the safety of current debt holders claims in the case of
default. Current ratio is calculated as follows:

Current ratio = Current assets
Current liabilities


The current ratio for Reunion Limited is as follows:

20.9 20.8
Current ratio Current ratio
= Current assets = Current assets
Current liabilities Current liabilities
= R1 275 800 = R1 213 200
R950 800 R763 800
= 1.34:1 = 1.59:1

A decline in the ratio (from 1.59:1 to 1.34:1) is largely due to the increase in current
liabilities from the previous year. An enterprise with a low current ratio may not be
able to convert its current assets into cash to meet maturing obligations. From a debt
holders point of view, a higher ratio appears to provide a cushion against losses in
the event of business failure. A large excess of current assets over current liabilities
seems to protect claims. However, from a management point of view a very high
current ratio may point towards slack management practices. It may indicate idle
cash, high inventory levels that may be unnecessary and poor credit management
resulting in overextended accounts receivable. The norm of 2:1 may also be used.

5.1.2 Acid test ratio
This ratio is a more stringent test of liquidity. The intention of the acid test ratio is to
test the collectability of current liabilities under distress conditions, on the
assumption that inventories would have no value at all. In the case of a real crisis
creditors may realise little cash from the sale of inventory. The acid test ratio is
similar to the current ratio except that the current assets (numerator) are reduced by
the value of the inventory. The calculation is done as follows:

Acid test ratio = Current assets Inventory
Current liabilities


Reunion Limited acid test ratio is as follows:

20.9 20.8
Acid test ratio Acid test ratio
= Current assets Inventory = Current assets Inventories
= R1 275 800 R462 400 = R1 213 200 R406 000
R950 800 R763 800
= R813 400 = R807 200
R950 800 R763 800
= 0.86:1 = 1.06:1

It is clear that a ratio of less than 1:1 would pose liquidity problems in the event of a
crisis. Reunion Limited faces this position at the end of 20.9 as the ratio indicates
there only R0.86 of liquid assets is available to settle every R1 of current liabilities.

5.2 Financial leverage
An enterprise increases its financial leverage when it raises the proportion of debt
relative to equity to finance the business. The successful use of debt enhances the
earnings for the owners of the enterprises since returns on these funds, over and
above the interest paid, belongs to the owners, and therefore increases the return on
owners equity. However, from the point of view of the lender, when earnings are
insufficient to cover the interest cost, fixed interest and principal commitments must
still be met. The positive and negative effects of leverage increase with the
proportion of debt in the enterprise. The most common measures of leverage
compare the book value of an enterprises liabilities to the book value of its assets or
equity.

5.2.1 Debt to assets
Debt to assets is used to reflect the proportion of debt to the total claims against the
assets of the enterprise. The greater the ratio, the higher the risk. Debt to asset ratio
is expressed as follows:


Debt to assets = Total debt X 100
Total assets 1

The Debt to assets ratio of Reunion Limited is as follows:

20.9 20.8
Debt to assets Debt to assets
= Total debt X 100 = Total debt X 100
= R1 598 200 X 100 = R1 521 400 X 100
R2 904 400 1 R2 779 200 1
= 55.03% = 54.74%

The ratio indicates that 55.03% of Reunion Limited assets, in book value terms, come
from creditors of one type or another. Creditors normally prefer low debt ratios since
the lower the ratio the greater the cushion against creditors losses in the event of
liquidation, a fall in demand, and low profits. Owners on the other hand, may seek
high gearing since it magnifies earnings and the sale of new shares means giving up
some degree of control.

5.2.2 Debt to equity
This ratio attempts to show the relative proportions of non-current claims to
ownership claims, and is used as a measure of debt exposure. Debt to equity ratio is
expressed as follows:

Debt to equity = Non-current debt X 100
Owners equity 1


The Debt to equity ratio of Reunion Limited is as follows:

20.9 20.8
Debt to equity Debt to equity
= Non-current debt X 100 = Non-current debt X 100
Owners equity 1 Owners equity 1
= R647 400 X 100 = R757 600 X 100
R1 306 200 1 R1 257 800 1
= 49.56% = 60.23%

The ratio indicates that the non-current creditors supply Reunion Limited with 49.65
cents for every Rand supplied by the owners. The ratios over the two year period
show a decrease in the use of non-current debt by the company. This ratio is
important because many lending agreements of companies contain covenants
regarding debt exposure expressed in terms of long-term debt to capitalisation
proportions.

5.3 Debt service
The above ratios still dont reveal a lot about the creditworthiness of the enterprise,
which involves the ability of the enterprise to meet its interest and principal on
schedule as contractually agreed upon. Our focus will be on interest coverage.

5.3.1 Interest coverage
This ratio is based on the premise that annual operating earnings are the basic source
for debt service, and that any major change in this relationship may signal difficulties.
Debt holders often stipulate the number of times the business is expected to cover its
debt service obligations. This ratio is of prime importance to a creditor. It measures
whether a company has sufficient profits to meet the interest payments on its debts.
The ratio for interest coverage is as follows:

I nterest coverage = Operating profit
Interest expense


Reunion Limited interest coverage ratio is as follows:

20.9 20.8
I nterest coverage I nterest coverage
= Operating profit = Operating profit
Interest expense Interest expense
= R611 600 = R591 200
R103 584 R121 216

Reunion Limited interest coverage of 5.90 times means that the enterprise earned its
interest obligations 5.90 times over in 20.9; profit before interest and tax was 5.90
times as large as interest. The company can therefore meet its interest obligations.


6. SUMMARY OF THE RATIOS
MANAGEMENT
6.1 Operational analysis
6.1.1 Gross margin = Gross profit X 100
Sales 1

6.1.2 Operating margin = Operating profit X 100
Sales 1

6.1.3 Profit margin = Net profit after tax X 100
Sales 1

6.2 Resource management
6.2.1 I nventory turnover = Cost of sales
Average inventory

6.2.2 Debtor collection period = Accounts receivable X 365
Credit sales

6.2.3 Creditor payment period = Accounts payable X 365
Credit purchases

6.2.4 Turnover to net assets = Sales
Net assets

6.3 Profitability
6.3.1 Return on assets = Operating profit X 100
Total assets 1

6.3.2 Return on capital employed = Operating profit X 100
Capital employed 1

OWNERS
6.4 Profitability
6.4.1 Return on equity = Profit after tax X 100
Owners equity 1

6.4.2 Earnings per share = Net profit after tax


6.5 Disposition of earnings
6.5.1 Dividend per share = Dividends for the year

6.5.2 Earnings retention ratio = Earnings per share Dividend per share X 100
Earnings per share
OR
6.5.2 Earnings retention ratio = Retained earnings for the year X 100
Profit due to ordinary shareholders

6.6 Market indicators
6.6.1 Price earnings ratio = Market price per share
Earnings per share

LENDERS AND CREDITORS
6.7 Liquidity
6.7.1 Current ratio = Current assets
Current liabilities

6.7.2 Acid test ratio = Current assets Inventory
Current liabilities

6.8 Financial leverage
6.8.1 Debt to assets = Total debt X 100
Total assets 1

6.8.2 Debt to equity = Non-current debt X 100
Owners equity 1

6.9 Debt service
6 9.1 I nterest coverage = Operating profit
Interest expense


7. SELF-ASSESSMENT ACTIVITIES

The following information relates to Simba Limited:
Income Statements for the year ended 31 December 20.9 and 20.8
20.9 20.8
Sales (all credit) 35 000 000 30 000 000
Cost of sales (all credit) (23 000 000) (20 000 000)
Gross profit 12 000 000 10 000 000
Operating expenses: (5 100 000) (4 000 000)
Distribution costs
Administrative expenses
2 000 000
3 100 000
1 500 000
2 500 000
Operating profit 6 900 000 6 000 000
Finance costs (400 000) (500 000)
Profit before tax 6 500 000 5 500 000
Income tax (1 500 000) (1 500 000)
Net profit after tax 5 000 000 4 000 000

Balance Sheets the year ended 31 December 20.9 and 20.8
Assets 20.9 20.8
Non-current assets 20 000 000 18 000 000
Property, plant and equipment 20 000 000 18 000 000
Current assets: 12 000 000 12 000 000
Inventories
Accounts receivable
6 000 000
5 000 000
1 000 000
6 000 000
4 000 000
2 000 000
Total assets 32 000 000 30 000 000
Owners equity and liabilities
Owners equity 20 000 000 18 000 000
Ordinary share capital 10 000 000 10 000 000
Retained earnings 10 000 000 8 000 000
Non-current liabilities 4 000 000 6 000 000
Current liabilities 8 000 000 6 000 000
Accounts payable 8 000 000 6 000 000
Total owners equity and liabilities 32 000 000 30 000 000


Statement of changes in equity for the year ended 31 December 20.9 and 20.8
20.9 20.8
Balance at end of previous year 18 000 000 16 500 000
Profit for the year 5 000 000 4 000 000
Ordinary share dividends (3 000 000) (2 500 000)
Balance at end of current year 20 000 000 18 000 000

Additional information
Simba Limiteds ordinary share capital consists of 10 000 000 ordinary shares with a
par value of R1 each.
The market price of the shares was R5.60 on 31 December 20.08 and R7.50 on
31 December 20.9.

Required
Calculate the following ratios for Simba Limited for 20.8 and 20.9 and comment on
your answers:
1. Gross margin
2. Operating margin
3. Profit margin
4. Inventory turnover (N.B. Inventories on 31 December 20.7 amounted to R6 000 000)
5. Debtors collection period
6. Creditors payment period
7. Turnover to net assets
8. Return on assets
9. Return on capital employed
10. Return on equity
11. Earnings per share
12. Dividend per share
13. Earnings retention
14. Price/Earnings ratio
15. Current ratio
16. Acid test ratio
17. Debt to assets
18. Debt to equity
19. Interest coverage

8. SOLUTIONS
THINK POINT 1
No, one cannot assume this all the time. A fall in gross margin could be the result of
a deliberate decision to increase sales. Likewise an increase in gross margin may be
due to a price increase that may actually show a fall in sales. One should therefore
determine the reasons behind the variation in the gross margin to arrive at a
conclusion on the performance of the company.

THINK POINT 2!
A low inventory turnover may mean that:
Demand for merchandise available on sale is low.
Items of inventory may be obsolete.
There is too much inventory.

A high inventory turnover may mean that:
There is a potential for inventory shortages and the resultant poor customer service.
Too little inventory is being carried in relation to the volume of sales.
There is a lower dependency on capital to carry inventory.

1.

20.9 20.8
Gross margin = Gross profit X 100 Gross margin = Gross profit X 100
Sales 1 Sales 1
= R12 000 000 X 100 = R10 000 000 X 100
R35 000 000 1 R30 000 000 1
= 34.29% = 33.33%

The gross margin has improved slightly. The improvement could be due to an
increase in selling price and/or reduced cost of purchases.


2.

20.9 20.8
Operating margin Operating margin
Sales 1 Sales 1
= R6 900 000 X 100 = R6 000 000 X 100
R35 000 000 1 R30 000 000 1
= 19.71% = 20%

Operating margin has decreased slightly. This may be due to operating expenses
increasing by a larger proportion than sales.

3.

20.9 20.8
Profit margin Profit margin
= Net profit after tax X 100 = Net profit after tax X 100
Sales 1 Sales 1
= R5 000 000 X 100 = R4 000 000 X 100
R35 000 000 1 R30 000 000 1
= 14.29% = 13.33%

Profit margin has improved despite the fact that operating expenses increased by a
larger proportion than sales. The increase is attributable to the decrease in finance
costs (a result of loan repayment).


4.

20.9 20.8
I nventory turnover I nventory turnover
= Cost of sales = Cost of sales
Average inventory Average inventory
= R23 000 000 = R20 000 000
R6 000 000 R6 000 000

Inventory levels have remained constant while sales have increased, resulting in a
higher inventory turnover for 20.9.

5.

20.9 20.8
Debtor collection period Debtor collection period
= Accounts receivable X 365 = Accounts receivable X 365
Credit sales Credit sales
= R5 000 000 X 365 = R4 000 000 X 365
R35 000 000 R30 000 000
= 52.14 days = 48.67 days

It is taking the company a few days longer than the previous year to collect money
from debtors. If the credit terms are 30 days, then debtors are taking too long to pay
and steps need to be taken to improve the collection period.


6.

20.9 20.8
Creditor payment period Creditor payment period
= Accounts payable X 365 = Accounts payable X 365
Credit purchases Credit purchases
= R8 000 000 X 365 = R6 000 000 X 365
R23 000 000 R20 000 000
= 126.96 days = 109.50 days

Note: Total purchases equal cost of sales since opening and closing inventories have not
changed. All purchases are on credit.

Creditors have increased by a larger proportion than credit purchases. The company
is taking longer to pay its creditors than the previous year and is almost certainly
exceeding the credit terms allowed by creditors (usually between 30 and 90 days).

7.

20.9 20.8
Turnover to net assets Turnover to net assets
Sales Sales
Net assets Net assets
= R35 000 000 = R30 000 000
R32 000 000 R8 000 000 R30 000 000 R6 000 000
= R35 000 000 = R30 000 000
R24 000 000 R24 000 000
= 1.46:1 = 1.25:1

The sales generated by each rand of net assets have increased from R1.25 to R1.46.
There has been an improvement in the utilisation of assets.


8.

20.9 20.8
Return on assets Return on assets
= R6 900 000 X 100 = R6 000 000 X 100
R32 000 000 1 R30 000 000 1
= 21.56% = 20%

Reunion Limited experienced a slight improvement in profitability. It needs to
compare this return to other similar companies, the inflation rate, return on alternative
investments, and interest rate on borrowed capital to determine whether it is satisfied
with the return.

9.

20.9
Capital employed 1
= R6 900 000 X 100
R24 000 000 1
= 28.75%


20.8
Capital employed 1
= R6 000 000 X 100
R24 000 000 1
= 25%

The return on capital employed has improved. The return appears to be greater than
the prevailing rate of interest and it is therefore considered to be satisfactory.

10.

20.9
Return on equity
Owners equity 1
= R5 000 000 X 100
20 000 000 1
= 25%

20.8
Return on equity
Owners equity 1
= R4 000 000 X 100
R18 000 000 1
= 22.22%

Profitability for shareholders has increased since profits have increased more than the
increase in owners equity. When compared to alternative investment opportunities,
shareholders should be fairly satisfied with this return.


11.

20.9 20.8
= Net profit after tax Net profit after tax
= R5 000 000 X 100 = R4 000 000 X 100
10 000 000 10 000 000

The improvement in the profitability of the company is evident in the EPS which has
increased by 10 cents per share.

12.

20.9 20.8
Dividend per share Dividend per share
= Dividends for the year Dividends for the year
= R3 000 000 X 100 = R2 500 000 X 100
10 000 000 10 000 000

DPS has increased by 5 cents per share. The increase in the EPS allowed the
company to declare higher dividends during 20.9.


13.

20.9
= 50 cents 30 cents X 100
50 cents 1
= 20 cents
50 cents
= 40%
OR
20.9
= R5 000 000 R3 000 000 X 100
R5 000 000 1
= R2 000 000 X 100
R5 000 000 1
= 40%

20.8
= 40 cents 25 cents X 100
40 cents 1
= 15 cents
40 cents
= 37.50%


OR
20.8
= R4 000 000 R2 500 000 X 100
R4 000 000 1
= R1 500 000 X 100
R4 000 000 1
= 37.50%

It appears that the company retains about 40% of the profit. This implies that the
dividend payout ratio is about 60% which is a fairly high. The earnings retention has
increased from 37.5% to 40%.

14.

20.9 20.8
Price earnings ratio Price earnings ratio
= Market price per share = Market price per share
50 cents 40 cents
= 15 times = 14 times

The market price of the shares has increased by an even greater proportion than the
earnings per share suggesting investor optimism in the company.


15.

20.9 20.8
Current ratio Current ratio
= Current assets = Current assets
= R12 000 000 = R12 000 000
R8 000 000 R6 000 000
= 1.50:1 = 2:1

Liquidity position has deteriorated due to the increase in current liabilities. Since
only R1.50 is available for every R1 short-term debt, the company may experience
difficulty in paying its short term debts as it is not easy to convert current assets such
as inventories into cash at short notice.

16.

20.9 20.8
Acid test ratio Acid test ratio
= Current assets Inventory = Current assets Inventories
= R12 000 000 R6 000 000 = R12 000 000 R6 000 000
R8 000 000 R6 000 000
= R6 000 000 = R6 000 000
R8 000 000 R6 000 000
= 0.75:1 = 1:1

Liquidity position has deteriorated. Without relying on the sale of inventories, the
company would not be able to pay its short-term debts (only R0.75 available for
every R1 owed).


17.

20.9 20.8
Debt to assets Debt to assets
= Total debt X 100 = Total debt X 100
= R12 000 000 X 100 = R12 000 000 X 100
R32 000 000 1 R30 000 000 1
= 37.50% = 40%

The proportion of debt to assets has decreased. 37.50% of assets are financed by
debt. From a creditors point of view the risk in the company is lower.

18.

20.9 20.8
Debt to equity Debt to equity
= Non-current debt X 100 = Non-current debt X 100
Owners equity 1 Owners equity 1
= R4 000 000 X 100 = R6 000 000 X 100
R20 000 000 1 R18 000 000 1
= 20% = 33.33%

The financial risk in the company is lower. This is due to the decrease in non-current
debt as well as an increase in owners equity. The low ratio leaves the door open to
take additional loans should the need arise.


19.

20.9 20.8
I nterest coverage I nterest coverage
= Operating profit = Operating profit
Interest expense Interest expense
= R6 900 000 = R6 000 000
R400 000 R500 000
= 17.25 times = 12 times

Interest coverage has increased which reduces the risk for lenders. The improvement
is due the reduced borrowings, reduced interest expense and higher operating profit.


TOPIC 6
COST-VOLUME-PROFIT RELATIONSHIPS
LEARNING OUTCOMES
classify cost by their behaviour as fixed costs, variable costs, or mixed costs.
describe what is meant by cost-volume-profit (CVP) analysis.
outline the assumptions that CVP analysis depend on.
calculate the contribution margin, the contribution margin ratio, and the unit contribution
margin, and explain its importance and usefulness to managers.
explain how changes in the sales mix can affect projections using CVP analysis.
explain the meaning and significance of the break-even point.
calculate break-even point.
determine the effects of changes in selling price, sales volume and fixed costs on operating
profit.
determine volume necessary to achieve a target profit using the unit contribution margin.
calculate operating leverage and margin of safety and understand the use of these concepts to
managers.


CONTENTS
1. Cost behaviour
2. Cost classifications
3. Cost-volume-profit relationships

READING
Prescribed
9
th

Recommended
Thomson Learning: London. (Chapter 18)

Decisions, Third edition, Thomson South-Western: Canada. (Chapter M7)

Thomson South-Western: Singapore. (Chapter 6)

(Chapter 11)


1.

COST BEHAVIOUR
Having knowledge of how costs behave is important to management for a number of
reasons. Amongst other things it allows management to forecast profits as sales, costs and
production volume change. It is also useful for estimating costs. Estimated costs themselves
affect a number of management decisions e.g. whether to use excess capacity to produce
and sell a product at a lower price. Cost behaviour refers to the way in which a cost
changes as a related activity changes.

2.

COST CLASSIFICATIONS
The most common classification of cost behaviour is variable costs, fixed costs and semi-
variable (mixed) costs. Variable costs are costs that change in proportion to changes in the
volume of activity e.g. raw material cost to produce a product has a variable cost behaviour
pattern because an increase in the number of units produced will increase the total raw
materials cost. Fixed costs are costs that remain the same in total Rand amount as the level
of activity varies. For example rent expense is a fixed cost because rent expense will not
change irrespective of the level of production. The label of fixed or variable refers to the
behaviour of total cost in relation to a change in activity. However, when one examines
the behaviour of unit costs, the labels may be confusing since variable costs are the same
per unit but fixed cost per unit will vary as the level of activity changes.

? THINK POINT 1
Will you consider wages paid to employees in a factory to be a fixed cost or a variable
cost? Why?

An important assumption in cost behaviour pattern relates to the relevant range. Relevant
range refers to the range of activity over which the changes in the cost are of interest. This
relevant range assumption applies mostly to fixed costs. Returning to the example of rent
expense, it is apparent that a significant increase in the volume of production would require
more building space, and the rent expense would increase. To say that rent expense is fixed
means that over some relevant rage of production the total cost would not change. Another
important assumption is that the cost behaviour pattern is linear. This assumption
applies mainly to variable costs. As a result of economies of scale, quantity discounts and

other factors, variable costs will change slightly when expressed on a per unit basis. This
must be remembered when cost behaviour patterns are analysed.

Not all costs can be classified as either fixed or variable. Some are a combination of fixed
costs and variable costs and are called semi-variable or mixed costs. For example the total
electricity consumption at a factory changes with production levels as the number of
machine hours changes. However, if production drops to zero, electricity would still be
used for lighting and heating or cooling of plant facilities.

3. COST-VOLUME-PROFIT RELATIONSHIPS
Cost-volume-profit (CVP) analysis is an examination of the relationships among selling
prices, sales and production volume, costs and profits. In particular it examines the effect
on profits when there are changes in factors such as selling price, variable costs, fixed costs,
volume and the number of products marketed. CVP analysis puts management in a better
position to cope with various short-term planning decisions.

Using CVP analysis, managers would be able to get information to use in decision-making
relating to the following:
How profits are affected by a change in costs.
What effect a change in sales volume will have on profit.
The profit that is expected from a certain sales volume.
How many units need to be sold to achieve a targeted profit.
At what output of production will the income and costs be the same.
Setting selling prices.
Selecting the mix of products to sell.

In todays competitive business environment, management must make such decisions
quickly and correctly.


3.1

Contribution margin concept
One relationship among cost, volume and profit is the contribution margin. Contribution
margin is the difference between sales revenues and variable costs. The contribution margin
concept is useful as it gives insight into the profit potential of an entity.

3.2

The traditional income statement format and the contribution margin income
statement format
The following exhibit illustrates the difference between an income statement prepared
according to the traditional format and an income statement prepared according to a
contribution margin format:

Exhibit 5-1
INCOME STATEMENTS
Traditional format Contribution margin format
Sales
Cost of sales
R600 000
(400 000)
Sales
Variable costs
R600 000
(480 000)

Gross profit
Operating expenses
200 000
(120 000)
Contribution margin
Fixed costs
120 000
(40 000)

Operating profit R80 000 Operating profit R80 000

Contribution margin (as reflected in exhibit 5-1) means that this amount is the contribution
to fixed expenses and operating profit. As sales increases variable expenses will increase
proportionately, and so will contribution margin. However, fixed costs will not increase.

When the traditional income statement is used, incorrect conclusions may be drawn when
changes in activity levels are being considered because it is assumed that all expenses
change in proportion to changes in activity. This error is avoided when the contribution
model is used correctly.


3.3

An expanded contribution margin model
Marshall et al (2011: 463) recommend an expanded version of the contribution model for
analytical purposes. Its benefits are best understood when applying it to a single product.
The expanded model is:

Exhibit 5-2
Per unit x Volume = Total %
Sales
Variable costs
R

Contribution margin R x = R %
Fixed costs
Operating profit R

The following steps are recommended when using the model:
Express sales, variable costs and contribution margin on a per unit basis.
Multiply contribution margin per unit by volume to obtain total contribution margin.
Subtract fixed costs from total contribution margin to obtain operating profit.
Express contribution margin as a percentage of sales.

The above expanded model demonstrates the effect on operating profit of changes in selling
price, variable costs, fixed costs, or the volume of activity. In the examples that follow, you
will observe the following four relationships constantly interacting with one another:
Sales Variable costs = Contribution margin

Contribution margin Sales = Contribution margin ratio
Total contribution margin depends on the volume of activity
Contribution must cover fixed costs before an operating profit is earned.



Example 1 Calculation of operating profit
Suppose management needs to know the operating profit from a product with the following
sales, cost and volume figures:

Exhibit 5-3

Selling price per crate
Variable costs per crate
Fixed costs in respect of the product
Sales volume in crates
R30
R18
R80 000
8 000 crates

Applying the figures in the model results in the following operating profit:
Exhibit 5-4
Sales
Variable costs
R30
R18

Contribution margin R12 x 8 000 = R96 000 40%
Fixed costs (80 000)
Operating profit R16 000

Example 2 Drop in selling price and increase in sales volume
Suppose that management wants to know what would happen to operating profit if a R6 per
unit drop in selling price were to result in a sales volume increase of 4 000 units, to a total
of 12 000 units.
The operating profit will be:
Exhibit 5-5
Sales
Variable costs
R24
18

Operating loss (R8 000)

The calculations above clearly demonstrates to management not to implement the drop in
selling price by R6 as the result will be an operating loss of R8 000.


Example 3 Decrease in selling price accompanied by an increase in advertising
expense and an expected increase in sales volume
Suppose management wants to implement the same R6 drop in the selling price per unit
accompanied by a R6 000 increase in advertising expense, with the prediction that sales
volume will increase to 19 000 crates.
Operating profit is expected to be:

Exhibit 5-6
Sales
Variable costs
R24
18


The calculations suggest that if the sales volume increase is possible from the price cut and
increased advertising (fixed cost), then operating profit will increase from its current level.
However, the relevant range assumption must be considered here as a large increase in sales
volume is likely to have an impact on fixed costs.

Example 4 Calculating the volume of sales required to achieve a target level of
operating profit
Using the original data from example 1, suppose management wants to know the sales
volume required to achieve an operating profit of R46 000. The solution entails recording
the known data in the model and working to the middle to obtain the required sales volume:

Exhibit 5-7
Sales
Variable costs
R30
R18

Contribution margin R12 x ? = R126 000 40%

The required sales volume is 10 500 units (R126 000 R12).


Example 5 Effect on contribution margin and operating profit when a change in
operations is expressed in terms of total sales.
Suppose the contribution margin is 40% and total sales are predicted to increase by
R24 000.

Using the marginal income ratio, it is expected that contribution margin and operating
profit will increase by R9 600 (R24 000 X 40%) provided that fixed costs did not change.

Example 6 Increase in sales and sales volume required to cover an increase in fixed
costs
Suppose fixed costs were to increase by R18 000, selling price is R15 per unit and the
contribution margin ratio is 40%.

The contribution margin has to increase by the same amount if operating profit was to
remain the same. Sales will have to increase by R45 000 (R18 000 40%) to earn a
R18 000 increase in contribution margin. The sales volume increase that is required to
generate the additional sales is calculated by dividing R45 000 by the selling price per unit,
which is R15. The volume increase is 3 000 units (which can also be calculated by dividing
the increased contribution margin required R18 000 by the margin contribution of R6 per
unit).

Example 7 Determining sales and contribution margin changes when per unit data
is not available or applicable
The contribution margin model is often used to analyse the impact of an entire product line
(e.g. a chocolate bar brand) that is sold in a variety of package or size configurations (with
each configuration having virtually the same contribution margin ratio). Suppose a product
line had a contribution margin of 40%, would an advertising programme costing R36 000
be effective if it generated an additional R100 000 of sales?

The increase in contribution margin would be R40 000 (R100 000 X 40%) which is R4 000
more than the cost of the advertising. Thus the program would be cost effective.


3.4

Sales mix considerations
The sales mix issue must be considered when applying the contribution margin model using
data for more than one product. Sales mix is the relative distribution of sales among the
various products sold by an entity. Since different products often have different
contribution margin ratios, the average contribution margin ratio for a given mix of
products will vary if the sales mix of the products vary.

Exhibit 5-8 illustrates the effect of a change in the sales mix. You will notice that though
sales volume remained the same (6 000 units), total sales increased (from R135 000 to
R138 000) and operating profit decreased (from R16 000 to R14 800). This can attributed
to the sale of more units of product X (with a lower contribution margin ratio) than product
Y (which had a higher contribution margin ratio). Consequently the companys average
contribution margin ratio also dropped (from 35,6% to 33,9%).

When an entity markets products of varying degrees of quality, products of a higher quality
usually have higher contribution margin ratios and marketing efforts are usually
concentrated on those products. Entities that market products with similar contribution
margin ratios do not have to be concerned about changes in the sales mix. Marketing efforts
can be more evenly spread.

Exhibit 5-8
(1). Assume that a company market 2 products. Shown below are per unit sales, variable costs and product volumes for current operations:
Product X Product Y Total for company
Per
unit

x

Volume

=

Total

%
Per
unit

x

Volume

=

Total

%

Total

%
Sales
Variable costs
R25
R18
3 000 R75 000

Sales
Variable costs
R20
R11
3 000 R60 000 135 000 100%
Contribution margin R7 x 3 000 = R21 000 28% Contribution margin R9 x 3 000 = R27 000 45% R48 000 35,6%
Fixed costs Fixed costs (32 000)
Operating profit Operating profit R16 000

(2). Now assume a change in the sales mix: Sales volume of product X increases to 3 600 units and sales volume of product Y drops to 2 400.
Product X Product Y Total for company
Per
unit

x

Volume

=

Total

%
Per
unit

x

Volume

=

Total

%

Total

%
Sales
Variable costs
R25
R18
3 600 R90 000

Sales
Variable costs
R20
R11
2 400 R48 000 138 000 100%
Contribution margin R7 x 3 600 = R25 200 28% Contribution margin R9 x 2 400 = R21 600 45% R46 800 33,9%


3.5

Break-even point
The break-even point is the level of operations at which the revenues of an entity are equal
to its total costs. In other words the entity has neither a profit nor a loss from operations.
Expressed in another way it is the point at which operating profit is equal to zero.

? THINK POINT 2
Of what significance is the break-even point to management?

There are various ways of calculating the break-even point. We will use the contribution
margin model to determine the break-even point. The break-even point can be calculated in
terms of units and revenues (Rand value). The following exhibit will be used to illustrate
this:

Exhibit 5-9
Sales
Variable costs
R30
R18

Contribution margin R12 x ? = ? 40%
Operating profit 0

In terms of the model, contribution margin must be equal to the fixed costs in order to
break-even. Therefore:

Exhibit 5-10

Break even quantity =

Fixed costs

=

=
Contribution margin per unit

R96 000
R12

8 000 units



Total revenues at break even =

Fixed costs

OR

=

=

Contribution margin ratio

R96 000
40%

R240 000
No. of units X Revenue
per unit
= 8 000 X R30

= R240 000

3.6

Target-profit analysis
A target profit is the operating profit that an entity wants to achieve over a stated period.
CVP analysis can also be used to determine the sales (in units or Rand value) needed to
achieve a target profit. This can be done by modifying the break-even formula stated above.
Using the information from exhibit 5-9 and a target profit of R24 000:

Exhibit 5-11
Target sales volume = Fixed costs + Target profit

=

=
R96 000 + R24 000
R12
10 000 units

Target sales value = Fixed costs + Target profit

=

=

R96 000 + R24 000
40%
R300 000

3.7

Operating leverage
Each change to an entitys revenue due to volume of activity changes results in a
proportionate change to variable expenses and contribution margin. However, since fixed
costs will not change, operating profit will change proportionately more than changes in
sales. The extent of the effect on operating profit due to a change in sales is called
operating leverage. Operating leverage is calculated as follows:
Exhibit 5-12

Operating leverage = Contribution margin
Operating profit



A high contribution margin ratio results in a high operating leverage. Thus entities with
high fixed costs will have a high operating leverage. This is characteristic of capital-
intensive industries e.g. airline industry. A high operating leverage increases the risk that a
small percentage drop in sales will cause a relatively larger percentage decrease in
operating profit. Entities that are labour-intensive usually have a low operating leverage.

Exhibit 5-13 illustrates the impact of high- and low- operating leverage. Part A indicates
the current position (before any changes in sales volume). Part B indicates the effect of an
increase in sales volume from 20 000 to 22 000 units. Macro Ltds operating profit
increased by 30% (72 000/240 000 X 100) and the increase is at a much greater rate than
the 15% (36 000/240 000 X 100) achieved by Micro Ltd. Part C indicates the effect of a
decrease in sales volume from 20 000 to 18 000 units. It shows that Macro Ltds operating
income decreased at a much greater rate (R72 000/R240 000 = 30%) than Micro Ltd (R36
000/R240 000 = 15%).


Exhibit 5-13

Two entities manufacture similar products but they chose different cost structures. Micro Ltd is labour intensive with relatively high variable costs and
relatively low fixed costs. Macro Ltd is capital intensive with relatively low variable costs and relatively high fixed costs. Each entity currently sells 20 000
units of the product. The following is the contribution model for each firm.

A.
Micro Ltd Macro Ltd
Per
unit

x

Volume

=

Total

%
Per
unit

x

Volume

=

Total

%
Sales
Variable costs
R60
R42

Sales
Variable costs
R60
R24

Contribution margin R18 x 20 000 = R360 000 30% Contribution margin R36 x 20 000 = R720 000 60%
Fixed costs (R120 000) Fixed costs (R480 000)

Parts B and C of this exhibit will examine the effects of an increase and a decrease in sales volume respectively.


B. Effect on operating profit of an increase in sales volume from 20 000 units to 22 000 units.
Micro Ltd Macro Ltd
Per
unit

x

Volume

=

Total

%
Per
unit

x

Volume

=

Total

%
Sales
Variable costs
R60
R42

Sales
Variable costs
R60
R24


C. Effect on operating profit of a decease in sales volume from 20 000 units to 18 000 units.
Micro Ltd Macro Ltd
Per
unit

x

Volume

=

Total

%
Per
unit

x

Volume

=

Total

%
Sales
Variable costs
R60
R42

Sales
Variable costs
R60
R24



NOTES:


3.8

Margin of safety
The margin of safety is the amount by which the actual level of sales exceeds the break-
even point. It is the amount by which the sales volume may drop before losses are incurred.
If the margin of safety is low, even a small decrease in sales revenue may result in an
operating loss. The margin of safety may be expressed as a percentage and is calculated as
follows:

Exhibit 5-14

Margin of safety =

Sales Break-even sales

X 100
Sales

If sales are R125 000, the unit selling price is R12,50, and the sales at break-even point are
R100 000, the margin of safety is 20%, calculated as follows:

Exhibit 5-15

Margin of safety =


X 100

=

=
Sales

R125 000 R100 000
R125 000

20%

X 100

The margin of safety in terms of Rand sales is R25 000 (R125 000 R100 000 or
R125 000 X 20%). The margin of safety can also be expressed in units. In this case it
would be 2 000 units (R25 000 R12,50). This means that present sales may decrease by
R25 000 or 2 000 units before an operating loss results.


4. SELF-ASSESSMENT ACTIVITIES AND SOLUTIONS
4.1 Classify the following costs as fixed or variable in terms of the level of output. Place a tick
in the appropriate column.

No. Cost Fixed cost Variable cost
1. Rent expense
2. Direct materials
3. Property rates and taxes
4. Commission of salesperson
5. Depreciation using straight-line method
6. Direct labour
7. Insurance
8. Salary of factory manager

4.2

AIM Ltd supplies component J to furniture manufacturers. The marketing manager is of the
opinion that if the selling price of component J is reduced, sales could increase by 25%.
The following information is available:

Selling price per unit
Sales volume
Variable cost per unit
Fixed costs
Operating profit
Present
R6
100 000 units
R4
R140 000
R60 000
Proposed
R5
25% more
R4
R140 000
?

4.2.1
4.2.2

4.2.3
Required
Calculate the expected profit or loss on the marketing managers proposal.
Calculate the number of sales units required under the proposed price to make a profit of
R60 000.
Calculate the sales value required under the proposed price to make a profit of R60 000.


4.3 Yashik CC manufactures one product. The following details relating to the product applies:

Variable costs per unit
Total fixed cost
Number of units sold
R72
R36 000
R82
6 000

4.3.1
4.3.2

Required
Calculate the break-even quantity and break-even value.
Calculate the margin of safety in terms of units and value.

4.4

Kivi Ltd manufactures and sells only one product. The budgeted details for 20.7 are as
follows:
Sales (units)
Variable cost per unit
Total fixed cost
150 000 per month
R3
R1,40
R1 350 000

4.4.1
4.4.2
4.4.3

4.4.3.1
4.4.3.2
4.4.3.3
Required
Calculate the budgeted profit for 20.7.
Calculate the break-even quantity and value.
Suppose Kivi (Pty) Ltd wants to make provision for a 10% increase in fixed costs and an
increase in variable costs by R0,20 per unit. Taking these increases into account, calculate
the following:
New break-even quantity and value
Safety margin (in terms of value)
The number of units that need to be sold to earn an operating profit of R400 000

4.5

HJK Limited sells two products viz. product A and product B. The fixed costs are
R300 000 and the sales mix is 60% product A and 40% product B. The unit selling price
and unit variable cost for each product are as follows:
Products Unit selling price Unit variable cost
Product A
Product B
R2,80
R2,00
R1,10
R0,80



4.5.1
4.5.2
Required:
Calculate the total break-even quantity.
How many units of each product would be sold at break-even point?

4.6

FMB Enterprises sales for March 20.7 was R200 000. Operating profit was R20 000.
Variable costs are usually 60% of sales. Suppose sales dropped by 15% in April to
R170 000. Would it be correct to say that operating profit will decline by 15% to R17 000?
Motivate your answer.
4.7

4.8
Explain the effect of a high operating leverage on profit from operations when there is a
small increase in sales.

How can an entity with a low operating leverage increase its operating profit significantly?

4.9

When an entitys operating leverage becomes high, so too does the operating risk. What
steps could you, as a manager, take to reduce the risk?

4.10

Furnichum Manufacturers manufacture lounge suites that sell for R3 000 per suite. They
have the same basic design but may vary the fabric coverings. It has the capacity to produce
1 400 lounge suites each month although production very seldom exceeds 1 000 per month.
The sales manager received a request from a cut-price discounter (with many branches)
who made an offer to buy 300 lounge suites at R2 400 per suite. The latest monthly figures
reveal the following:

Per unit x Volume = Total
Sales
Variable costs
R3 000
R1 800
x
x
900
900
R2 700 000
(1 620 000)
Contribution margin R1 200 x 900 = R1 080 000

Would you advise the sales manager to accept or reject the sales offer? Substantiate your
answer.


4.11

Wheeler Ltd, a small company, is a mini-bus builder. It has the capacity to build 50 mini-
buses per year. The company has been able to sell all the mini-buses it produced each year.
The selling price of each mini-bus is R200 000. Variable costs are R76 000 per mini-bus.
The fixed costs of running the business are R2 500 000 per year. Last year the company
made an operating profit of R3 700 000 on sales of R10 000 000.

The directors are considering expanding the operations especially now that the property
next to the company is vacant and it would be possible to produce another 20 mini-buses
per year. They are confident that with the governments new laws on re-capitalisation in the
taxi industry (which forces taxi owners to change their existing small mini-buses to larger,
safer ones) will favour them as their mini-buses comply with the governments
specifications. They thus believe that they will be able to sell another 20 buses per year.

They estimate that the expansion will result in an additional R2 000 000 fixed costs with no
change to the variable costs per mini-bus. Should the directors accept or reject the proposal
to expand? Motivate your answer.

SOLUTIONS

? THINK POINT 1
Wages appears to be a variable cost since total wage costs vary according to the number of
hours worked. However, when a factory is producing below expected volume, in many
cases the employees are not asked to go home but remain at work. In other words, each
employee still works for the normal working week duration (e.g. 45 hours). In this case the
wages of the hourly paid employees is considered to be a fixed cost as the total hours
worked does not vary with production.

? THINK POINT 2
It provides the minimum sales target that must be achieved before an entity can start
showing a profit. Expressed another way, it is the sales level that must be reached before an
entity ceases to be unprofitable. Many managers find it simpler to think in terms of sales
rather than fixed and variable costs. Break-even point is a useful planning tool, especially
when decisions have to be made whether to increase or decrease operations.

4.1
No. Cost Fixed cost Variable cost
1. Rent expense
2. Direct materials
3. Property rates and taxes
4. Commission of salesperson
5. Depreciation using straight-line method
6. Direct labour
7. Insurance
8. Salary of factory manager

4.2.1 Expected profit or loss Per unit x Volume = Total %
Sales
Variable costs
R5
R4

Contribution margin R1 x 125 000 = 125 000 20%
Operating loss (15 000)

4.2.2 Target sales volume = Fixed costs + Target profit

=

=
R140 000 + R60 000
R1
200 000 units

4.2.3

Target sales value = 200 000 X R5 = R1 000 000
This amount can also be calculated as follows:

4.2.3 Target sales value = Fixed costs + Target profit

=

=

R140 000 + R60 000
20%
R1 000 000


4.3 Per unit x Volume = Total %
Sales
Variable costs
R82
R72
6 000
6 000
492 000
(432 000)

Contribution margin R10 x 6 000 = 60 000 12,195%
Operating profit 24 000

4.3.1


Fixed costs

=

=

R36 000
R10

3 600 units

4.3.1


Fixed costs

=

=


R36 000
12,195%

R295 200 (rounded off)

(OR 3 600 X R82)

4.3.2

Margin of safety =
(in terms of units)
=
=
Sales units Break-even sales units

6 000 3 600
2 400 units
4.3.2

Margin of safety =
(in terms of value)
=
=
R492 000 R295 200
R196 800


4.4.1 Per unit x Volume = Total %
Sales
Variable costs
R3
R1,40

Contribution margin R1,60 x 1 800 000 = 2 880 000 53,333%
Fixed costs (1 350 000)
Operating profit 1 530 000

Note: Sales volume = 150 000 X 12 months = 1 800 000

4.4.2


Fixed costs

=

=

R1350 000
R1,60

843 750 units

4.4.2


Fixed costs

=

=


R1 350 000
53,333%

R2 531 250 (rounded off)

(OR 843 750 X R3)

4.4.3 Per
unit
x Volume = Total %
Sales (Volume:150 000 X 12)
Variable costs (R1,40 + R0,20)
R3
R1,60
1 800 000 5 400 000

Contribution margin R1,40 x 1 800 000 = 2 520 000 46,667%
Fixed costs (R1 350 000 +R135 000) 1 485 000



4.4.3.1


Fixed costs

=

=

R1 485 000
R1,40

1 060 714 units

Total revenues at break even
=

Fixed costs

=

=


R1 485 000
46,667%

R3 182 120 (rounded off)

(OR 1 060 714 X R3)

4.4.3.2

Margin of safety =
(in terms of value)
=
=
Budgeted sales Break-even sales
R5 400 000 R3 182 120
R2 217 880

4.4.3.3 Target sales volume = Fixed costs + Target profit

=

=
R1 485 000 + R400 000
R1,40
1 346 429 units

4.5
Product A + Product B = Total
Selling price R2,80 R2,00
Variable cost per unit R1,10 R0,80
Contribution margin per unit (R1,70 X 60%) + (R1,20 X 40%) = R1,50



4.5.1


Fixed costs

=

=

R300 000
R1,50

200 000 units

4.5.2

Break-even quantity of product A = 200 000 X 60% = 120 000 units
Break-even quantity of product B = 200 000 X 40% = 80 000 units

4.6 INCOME STATEMENTS
May 20.7 April 20.7
Sales
Variable costs (60%)
200 000
(120 000)
Sales
Variable costs (60%)
170 000
(102 000)

Contribution margin
Fixed costs
80 000
(60 000)
Contribution margin
Fixed costs
68 000
(60 000)

Operating profit 20 000 Operating profit 8 000

The answer is no. From the calculations above it is clear that operating profit will drop by
R12 000 to R8 000 (and not drop to R17 000). Since fixed costs remained unchanged, the
R12 000 decrease in contribution margin (resulting from the 15% decrease in sales) reduced
the operating profit by the same amount. This illustrates the point that fixed costs behave
differently from variable costs.

4.7

A high operating leverage indicates that a small increase in sales will result in a large
percentage increase in operating profit.

4.8

An entity with a low operating leverage requires a large increase in sales to increase its
operating profit significantly.

4.9

In order to reduce the operating risk, it is necessary to reduce fixed costs. This may not be
easy to do especially with costs that cannot be eliminated in the short-term e.g. long-term
lease of the premises. However, one needs to identify fixed costs that can be eliminated in a
relatively short term e.g. a renewable monthly advertising contract.

4.10

First, we need to determine whether the contribution margin of the proposal is positive or
not:
Per unit
Sales
Variable costs
R2 400
R1 800
Contribution margin R600

Since the contribution margin is positive, the sale at a discount of R600 per lounge suite is
still profitable. However other factors must also be considered. These include:
Once the discounter starts selling the lounge suites at R600 less than the usual price, the
manufacturers other customers will refuse to pay the normal price of R3 000 in future.
If the manufacturer had a reputation for high quality, this could be damaged by its
association with a price discounter.

4.11

If the proposal is to be accepted, the increase in revenue (incremental revenue) must be
greater than the increase in costs (incremental costs). The increase in profit (incremental
profit) is calculated as follows:

Incremental sales (20 X R200 000)
Incremental variable costs (20 X R76 000)
R
4 000 000
(1 520 000)

Incremental contribution margin
Fixed costs
2 480 000
(2 000 000)

Incremental operating profit 480 000

Decision: Since the incremental profit is a positive, it appears as though the company
should increase its capacity. However, the directors should also consider that the operating
profit percentage on the additional sales at 12% is much lower than the existing operating
profit percentage of 37% (R3 700 000/R10 000 000 X 100).


TOPIC 7
COST ANALYSIS FOR PLANNING, CONTROL AND DECISION-MAKING

LEARNING OUTCOMES
explain the role of budgeting in planning and control.
outline the significance of the sales budget to the overall operating budget.
describe and how a purchases or production budget is drawn up.
explain how the other budgets are essential to the preparation of a budgeted income
statement, cash budget and a budgeted balance sheet.
define and what standard costing means.
explain the advantages of standard costing.
calculate material, labour, manufacturing overheads and sales variances
explain the meaning of cost terminology used in the decision-making process.
outline how costs are determined for short-run decisions.
appreciate the importance of relevant costs in short-term decision-making.
evaluate capital investment proposals using the following methods: payback period,
accounting rate of return, net present value and internal rate of return.


CONTENTS
1. Cost analysis for planning
2. Cost analysis for control
3. Cost analysis for decision-making

READING
Prescribed
9
th
Edition, McGraw-Hill: New York. (Chapter 14, 15, 16)

Recommended
(Chapters 11 and 12)
Thomson Learning: London. (Chapters 16, 17)
Hand L., Isaaks C. and Sanderson P (2005) Introduction to Accounting for Non-Specialists, First
edition, Thomson Learning: London. (Chapter 9)
Decisions, Third edition, Thomson South-Western: Canada. (Chapters M1, M8 and M9)
Thomson South-Western: Singapore. (Chapters 9 and 10)
Management Accounting, Fifth edition, LexisNexis Butterworths: Durban. (Chapter 12)
(Chapters 11 and 12)
(Chapters 38, 39 and 40)


1.

COST ANALYSIS FOR PLANNING
Planning is an integral element of management. Planning involves creating a path for
achieving the entitys goals and objectives. Strategic planning involves an identification of
the long-term goals and drawing up plans to achieve them. Examples of strategic decisions
include entering a new market, producing a new product and extending the plant.
Operational planning involves developing objectives for day-to-day activities e.g.
determining how much to produce each day to meet sales requirements.

Managerial accounting plays an important role in both strategic and operational planning.
Long-term financial planning is an important part of strategic planning. Strategic long-term
financial plans set targets in terms of financial performance over many years in the future.
These strategic financial plans are supported by operational plans that forecast monthly,
quarterly or annual financial results needed to achieve the long-term financial plans.

1.1

1.1.1
Budgeting
A budget is a plan in financial terms that extends for a period in the future. It forms part of
the broader process of planning.
Advantages of budgets
Budgets are useful for the following reasons:
It forces management to plan thereby reducing the number of opportunities for off the
cuff decisions.
If the budget process is effective, staff may feel motivated to work hard to achieve both
strategic and operational objectives.
It allows managers to control business activities by comparing actual outcomes to the
budget.
It provides a basis by which performance can be measured.

? THINK POINT 1
What problems do you think may arise as a result of drawing up budgets?


1.1.2

Approaches to budgeting
The starting point of most budgets is the actual results for the present period. After
examining the recent costs and revenue, these amounts are adjusted for changes that are
expected in the following period. The problem with this incremental approach is that
inefficiencies in the ways things are done currently are carried into the future. Another
budgeting technique is called zero-based budgeting. With zero-based budgeting cost
estimates are built up from zero level and it rests on the philosophy that all spending must
be justified. It is not automatically accepted that if some activity was financed this year it
will be financed again in the future. A good case must be made for the allocation of scarce
resources for that activity.

1.1.3

The budgeting process
Budgets are often prepared for a budget period of one year and this is called a single-
period budget. However, the budget period can extend over a shorter or sometimes longer
period. Another, related type of budgeting is known as the rolling budget. The budget is
initially prepared for an appropriate budget period e.g. one year. With each month that
elapses, another month is added to the end of the budget, so that there will always be a full
12 month budget.

According to Marshall et al (2011: 543) the first step in budgeting is to develop a set of
broad assumptions about the economy, the industry and the entitys strategy for the budget
period. The operating budget (or master budget) is a collection of related budgets that
include the sales, purchases/production, material purchases, direct labour, manufacturing
overhead, operating expense, income statement, cash and balance sheet budgets.

The sales budget is first prepared. All other budgets depend on the sales forecast. The
quantity to be purchased or produced depends on expected sales and inventory levels. The
materials purchases, direct labour and manufacturing overhead budgets are prepared after
the production budget is drawn up. Selling expenses depend on sales while other operating
expenses depend on sales and purchases. A forecast income statement can now be prepared.
The cash budget can next be prepared followed, finally, by the forecast balance sheet.

A sales budget may be described as a forecast of the number of units the enterprise expects
to sell for a predetermined period. The reliability of the sales budget is important as all

other budgets are based on it. After the number of units that may be sold is estimated, the
number of units that can be produced may be determined. Whilst the sales budget depends
a lot on previous sales figures, consideration is also given to sales trends, future predictions
and competitors. Example of a simplified sales budget:

Exhibit 6-1
Sales budget for March 20.7
200 000 bottles of cooldrink @ R3each = R600 000

The purchases/production budget must be compatible with the sales budget. However,
other factors such as the inventory level held by the entity are important. The
purchases/production budget thus states the quantity of a product that must be purchased or
produced to meet an entitys sales and inventory requirements. A basic
purchases/production budget is as follows:

Exhibit 6-2
Sales forecast (in units)
Desired closing inventory of finished goods
200 000
30 000

Total budgeted purchases/production needs
Opening inventory of finished goods
230 000
(20 000)

Required purchases/production 210 000

Cost of sales budgets are drawn up by both merchandising and manufacturing entities. For
a merchandising entity, the cost of goods available for sale is first calculated by adding the
opening merchandise inventory to the budgeted purchases. Closing inventory requirements
are then deducted from this amount to determine the budgeted cost of sales. The process is
identical for a manufacturing entity except that expected cost of goods manufactured
replaces expected purchases.

The materials purchases budget is prepared once the production budget has been drawn
up. Many entities keep materials on hand at all times to accommodate unforeseen changes
in demand. A basic materials purchases budget for plastic bottles is as follows:


Exhibit 6-3
Plastic bottles required in production (Exhibit 6-2)
Desired closing inventory of plastic bottles
210 000
42 000

Total budgeted need for plastic bottles
Opening inventory of plastic bottles
252 000
(52 000)

Required purchase of plastic bottles 200 000
Cost per plastic bottle R0,30
Cost of plastic bottles to be purchased R60 000

The direct labour budget also depends on the production budget. It is prepared by
multiplying the number of direct labour hours needed to produce each unit by the number
of units to be produced. The following is an example of a direct labour budget:

Exhibit 6-4
Required production (in bottles) (exhibit 6-2)
Direct labour hours per bottle (500 bottles per hour)
210 000
1/500

Total direct labour hours needed for production
Direct labour cost per hour
420
R20

Total direct labour cost R8 400

In a manufacturing overhead budget overhead costs are estimated. These costs may be
determined in a number of ways including department predetermined overhead rates and
activity-based costing. The following is an example of a manufacturing overhead budget
using a predetermined overhead rate:

Exhibit 6-5
Budgeted machine hours (same as labour hours)
Variable overhead rate per hour
420
R50

Variable manufacturing overhead
Fixed manufacturing overhead
R21 000
R120 000

Total manufacturing overhead R141 000



The operating expense budget includes selling, general, administrative and other
operating expenses. Some of these expenses are variable e.g. commissions, delivery
expenses while others are fixed e.g. rent expense, insurance. The following is an example
of an operating expense budget:

Exhibit 6-6

Variable selling and administrative expenses
Sales commissions
Delivery costs
Supplies
R

27 000
10 000
2 000

Fixed selling and administrative expenses
Rent expense
Salaries
Depreciation
Other fixed expenses

20 000
15 000
1 000
8 000

Total selling and administrative expenses 83 000

The budgeted income statement is drawn up from the sales budget, cost of sales budget
and operating expense budget. It is a summary of the various component projections of
income and expenses for the budget period.

Once all the other budgets including the sales budget are prepared, the cash budget can be
drawn up. The cash budget shows the expected receipts and expected payments for a
certain period of time. It usually depicts the monthly cash position of the enterprise. The
cash budget is prepared for the purpose of cash planning and control. It helps in avoiding to
keep cash lying idle for long periods and identifying possible cash shortages.

A schedule showing the amounts expected to be collected from debtors for credit sales is
usually attached to the cash budget. Note that a cash budget only involves amounts that
affect the cash balance of the enterprise. Therefore non-cash items such as depreciation,
bad debts, discount allowed and discount received are not included. Since budgets are used
internally by an enterprise, the style may vary from business to business.


However, most cash budgets have the following features:
- The budget period is broken down into sub-periods usually months.
- Receipts of cash are identified and totalled.
- Payments of cash are identified and totalled.
- The surplus (or shortfall) in cash for each month is calculated (receipts minus payments).
- The closing cash balance is calculated by taking into account the cash surplus (or
shortfall) and the opening cash balance.

An example of the format of a cash budget appears in the self-assessment activities
(question 4.4).

A budgeted balance sheet is prepared by starting with the balance sheet for the period just
ended and adjusting it using all the activities which are expected to take place during the
budgeted period. A budgeted balance sheet can help management to calculate a variety of
ratios. It also highlights future resources, obligations and possible unfavourable conditions.
The budgeted balance sheet is affected by all the other budgets. Production and purchases
budgets will indicate inventory estimates. Depreciation reflected in the operating expenses
budget will affect the carrying value of non-current assets in the balance sheet. The
expected net profit or loss reflected in the budgeted income statement will affect retained
earnings. The cash budget is a source of many balance sheet amounts e.g. purchase of
equipment, payment of dividends etc.

2.

COST ANALYSIS FOR CONTROL
Control involves the comparison of actual outcomes with planned outcomes as stated in the
entitys strategic and operating plans. Control decisions involve matters relating to how
performance is evaluated, what measures to use and what types of incentives to use. At the
end of a particular period (e.g. a month, quarter, year etc), managers use the budget as a
control mechanism by comparing budgeted sales, purchases, and manufacturing costs to
actual sales, purchases and manufacturing costs. These comparisons are done through a
process called variance analysis. Variance analysis allows managers to determine whether
sales, purchasing and manufacturing costs are higher or lower than planned and more
importantly the reasons for the variance.



? THINK POINT 2
Managers are often advised to take action only when actual results deviate significantly
from planned. What could be possible reasons for this advice?

Standard costing is useful in variance analysis. A standard cost is a predetermined target
cost that aims to provide a benchmark against which to measure actual performance.
Factors such as quantities, prices, rates of pay and quality are considered in the setting of a
standard. Standards may be set for materials, labour, manufacturing overheads and selling
prices. All variances from the standard cost are the result of two factors viz. price and
quantity. The variance could be either favourable or unfavourable to the enterprise.

2.1

Material standards and variances
When material standards are set consideration is given to prices, quantity, quality, grades,
wastages etc. A price and a quantity standard are set for material. The standard material
price is usually based on past, present and expected future prices and also gives
consideration to economic order quantities, suppliers quotations and market factors. The
standard material quantity specifies the quantity required to manufacture one unit of a
completed product. Two main variances can occur with respect to material viz. a price
variance and a quantity variance.

Raw materials price variance is calculated when raw materials are issued to production.
It is based on the number of units issued and used. It is the difference between the actual
quantity issued at actual cost and the actual quantity issued at standard price. The formula
for is:

Raw materials price variance
(Actual price Standard price) X Actual quantity issued

Raw material usage variance is the difference between the actual quantity of material
used (at the standard price) and the standard quantity of material allowed (at standard
price). Assume that 2 kg of raw material is used to manufacture one unit of a finished
product. If 200 units are manufactured, then the standard material quantity allowed is 400
kg (200 X 2 kg).

The formula is:

Raw material usage variance
(Actual quantity Standard quantity) X Standard price

2.2

Direct labour standards and variances
Direct labour standards are set in terms of rate (tariff) and efficiency (time). With respect to
rate, wages scales that have been devised for various types of labour usually form the basis
of the rate standards. Efficiency relates to how long it should take to complete a task.
Let us examine the two variances concerning direct labour viz. direct labour rate variance
and direct labour efficiency variance.

The direct labour rate variance is calculated by multiplying the difference between the
standard rate and the actual rate to the number of hours worked.
The formula is:

Direct labour rate variance
(Actual rate Standard rate) X Actual hours worked

The direct labour efficiency variance is related to the time it takes to manufacture a single
product. It is calculated by finding the difference between the actual hours worked (at
standard rate) and the standard time (hours) allowed for the actual production (at standard
rate).
The formula is:

Direct labour efficiency variance
(Actual time worked Standard time allowed) X Standard rate

2.3

Manufacturing overheads standards and variances
Manufacturing overheads may be classified as fixed or variable and standards are set
separately. Variable costs (the same for each product) change in direct proportion to level
of business activity. The fixed overhead rate is calculated according to a predetermined
level of business activity. Overhead variances may be due to equipment lying idle,
absenteeism, changes in demand, efficiency of employees, working conditions etc.

Separate variances in respect of variable and fixed overheads may be calculated as follows:

Variable overhead variance
Overhead rates are often based on direct labour hours (used in this module) or machine
hours.
The efficiency variance is calculated as follows:

Variable overhead efficiency variance
(Actual hours Standard hours allowed) X Standard rate
Note:
Standard hours allowed = Number of units produced X standard time to make one product
Standard rate = Standard variable overheads standard number of labour hours

The spending variance is calculated as follows:

Variable overhead spending variance
(Actual rate Standard rate) X Actual hours

Note:
Actual rate = Actual variable overheads actual number of labour hours
Standard rate = Standard variable overheads standard number of labour hours

The total fixed overheads variance is the difference between the actual fixed overheads
and the standard fixed overheads allowed. The spending variance and the volume variance
are the main fixed manufacturing overheads variances.

The spending variance is calculated as follows:

Fixed overhead spending variance
Actual fixed overheads Budgeted fixed overheads


The volume variance is calculated as follows:
Fixed overhead volume variance
Budgeted fixed overheads Standard fixed overheads
Note:
Standard fixed overheads = Number of units produced X Standard time to make 1 product
X Standard rate per hour
Standard rate per hour = Standard fixed overheads standard number of labour hours

2.4

Interpreting favourable and unfavourable variances
Variances that are favourable or unfavourable may not necessarily be interpreted as good or
bad. In order to interpret variances, the underlying causes must be determined. Suppose an
entity is investigating an unfavourable direct labour efficiency variance. The problem could
be with worker efficiency but the investigation may reveal that the workforce is fixed in the
short-term and there are not enough orders to keep the workers busy. The entity may not
want to lay off workers for short periods as the workers may find other jobs or it may be
costly to re-hire them.

An unfavourable direct material usage variance may point to a problem in production.
However, usage could be high because the purchasing manager may have purchased
inferior quality materials resulting in many defective products produced. In this case the
direct material usage variance would be unfavourable but the material price variance will
most likely be favourable.

Managements objectives are also important in interpreting variances. If, for example, cost
control takes priority, an unfavourable direct material price variance will most likely be
considered unacceptable. However, if managements main objective is to provide high-
quality products, an unfavourable material price variance may be acceptable if a higher
price is necessary to procure high quality materials.

Once managers have identified the root causes of the variance and have considered their
own objectives in using variance analysis, they can now effectively consider alternatives
available to resolve the problem.


3.

COST ANALYSIS FOR DECISION-MAKING
We now examine how costs are involved in the decision-making process and especially in
the short-term. We first start by explaining certain cost terminology used in decision-
making. Differential cost is the increase or decrease in cost that is expected from a course
of action as compared to an alternative. For example, if adding a new feature to an existing
product is being considered, only the changes in the cost resulting from the new feature
need to be considered relative to the additional revenues expected to be generated from
adding the new feature. Costs that still continue to be incurred, whether or not the new
feature is added, are not relevant to the decision.

Allocated costs are costs that are assigned to a product or activity e.g. overhead costs
allocated to production runs using a predetermined overhead rate. Since many cost
allocation methods are arbitrary, managers must be circumspect about decisions made from
an analysis that includes allocated costs.

A sunk cost is a past cost that cannot be changed or cancelled by some future action. An
example of such a cost is a long-term lease.

An opportunity cost refers to some measurable advantage that could have been gained
from the alternative use of resources. For example, a manufacturer has the option of renting
part of his factory for R3 000 per month or using it to manufacture an additional product. If
he decides to manufacture the additional product, he will sacrifice rent income that he could
have received. This is considered an opportunity cost.

3.1

Short-term decisions
When making decisions, some costs are relevant to a decision that is to be taken, while
other costs are irrelevant costs. The relevant costs are those costs that will be affected by
the decision, whilst the irrelevant coats will not be affected. Examples of short-term
decisions include the acceptance or rejection of a sales offer and make or buy decisions.

3.1.1

Acceptance of a sales offer
Suppose the monthly capacity of a South African sporting goods manufacturer is 13 000
soccer balls. Current sales and production average 10 000 soccer balls per month. The
current manufacturing cost consists of variable costs of R30 per unit and total fixed costs of

R260 000. The normal selling price of the soccer ball is R65 each. The manufacturer
receives an offer from the soccer world cup committee for 2 000 soccer balls at R45 each
for the 2010 soccer world cup. The pricing policies of its markets will not be affected.
Should the offer be accepted?

A comparison of the sales offer of R45 with the selling price of R65 indicates that the offer
should be rejected. However, by focussing on the relevant cost, which in this case is the
variable cost, the decision is different. Exhibit 6-7 illustrates why.

Exhibit 6-7

Differential revenue from accepting the offer:
2 000 units @ R45
Differential cost by accepting the offer:
2 000 units @ R30

R90 000

(R60 000)
Differential profit from accepting the offer. R30 000

The special offer price of R45 generates a contribution margin of R15 (R45 R30) and this
brings in R30 000 additional operating profit as no additional fixed costs were incurred
(given the idle capacity).

Let us examine what the operating profit would be if the entity was operating at full
capacity (13 000 units). If the entity rejects the sales offer, the operating profit at full
capacity would be:

Exhibit 6-8
Total: 13 000 units
Unit (R) Total (R)
Sales
Variable costs
65
30
845 000
(390 000)
Contribution margin
Fixed costs
35
20
455 000
(260 000)



If the entity accepts the offer while operating at full capacity, the effect on operating profit
is illustrated below:
Exhibit 6-9
Current sales
(11 000 units)
Sales offer
(2 000 units)
Total (R)
(13 000 units)
Unit (R) Total (R) Unit (R) Total (R) Total (R)
Sales
Variable costs
65
30
715 000
(330 000)
45
30
90 000
(60 000)
805 000
(390 000)
Contribution margin 35 385 000 15 30 000 415 000
Fixed costs (260 000) - (260 000)
Operating profit 125 000 30 000 155 000

By accepting the offer when operating at full capacity, the operating profit will decline by
R40 000 (R195 000 R155 000) i.e. 20,5% decrease. The difference in the contribution
margin of R20 (R35 R15) per soccer ball is the relevant opportunity cost the operating
profit foregone by accepting the offer than rejecting it.

3.1.2

Make or buy decision
The assembly of components is often a substantial element in the production of products
such as motor vehicles. The components may be made by the manufacturer of the product
or they can be purchased. In the make or buy decision the relevant cost of making a
component is the cost that can be avoided by acquiring the component from a source
outside the company. Costs that will continue to be incurred regardless of whether the
component is made internally or purchased from outside are not relevant to the decision.

Suppose a motor car manufacturer has been purchasing dash boards for R480 each. The
factory is presently operating at 85% of capacity, and no major increase in production is
expected in the near future. The unit cost of manufacturing the dash boards internally,
including fixed costs, is expected to be as follows:

Exhibit 6-10
Direct materials
Direct labour
Variable factory overhead costs
Fixed factory overhead costs
R160
R160
R104
R136
Total cost per unit R560


If the buy price of R480 is compared to the make price of R560, the decision would favour
buying the dash boards. However, if the unused capacity could be used to make the dash
boards then the fixed factory costs will not be considered to be a relevant cost. The relevant
costs would thus be the direct materials, direct labour and variable factory overhead costs.
The cost per unit is illustrated below:

Exhibit 6-11
Direct materials
Direct labour
Variable factory overhead costs
R160
R160
R104

It now appears that there would be a cost saving of R56 (R480 R424) if the dashboards
were manufactured internally. However, other factors must also be considered. The
capacity committed to the dashboards may not be available for more production
opportunities in the future. Business relations with the supplier of the dashboards, who may
supply other essential parts, may be affected.

3.2

Long-term decisions
Capital budgeting plays an important role in making long-term decisions. Capital
budgeting is a process of analysing capital expenditures e.g. investing in plant, equipment
etc to determine whether the investment will generate a satisfactory return on investment
over time.

A sum of money today has a greater value than the same amount at any time in the future.
This may be due to the effects of inflation, risk and loss of interest. The present value of
money is very important in capital investment appraisal. In order to eliminate the number
of steps to calculate the present value of any amount, present value tables are available.
The present value of R1 can be read from the tables.


3.2.1

Capital investment appraisal using techniques that ignore the time value of money
When appraising investment decisions, net cash flows need to be calculated. Net cash flow
is the difference between the cash inflow arising from an investment and the cash outflow
that it requires. However, the minimum rate of return of an investment should be greater
than the interest rate on borrowed funds or rate of return of the enterprise (depending on the
source of financing borrowed or own). The following techniques that ignore the time
value of money may be used to evaluate capital investment projects:
Payback period
Accounting rate of return

3.2.1.1

Payback period
Payback period measures the amount of time required to recover the initial cost of the
investment from the net cash inflows from the project. The general decision rule to follow
is to choose the project with a shorter payback period. The reason for this is that the
shorter the payback period, the less risky the project and the greater the liquidity.
Payback period is calculated as follows if the net cash inflow is the same each year:

Cost of project

Net cash inflow (p.a.)

3.2.1.2

Accounting rate of return (ARR)
The accounting rate of return (ARR) measures profitability by relating the average
investment to the future annual net profit. In other words, ARR uses the average profit an
investment will generate and expresses it as a percentage of the average investment over
the life of the project. The project that is expected to realise a higher rate of return is
chosen.
The accounting rate of return of an investment is calculated as follows:

ARR =

Average annual profit
Average investment

X 100
1

The average investment in respect of a machine is calculated as follows:

Average investment =

Cost of machine + Disposal value or scrap value or residual value
2

3.2.2

Capital investment appraisal using discounted cash flow methods
Since the two methods described above do not take into account the time value of money,
the following methods are widely used to evaluate investment opportunities:
Net present value (NPV)
Internal rate of return (IRR)

3.2.2.1

Net present value (NPV)
By applying the present value method, the present values of future cash flows are
calculated using the enterprises minimum rate of return. The net present value is the
difference between the present value of the projected cash inflows and the present value of
the cash outflows. If the NPV is positive, then the project is considered for acceptance. If
the NPV is negative, the project is rejected since it would not be profitable.

3.2.2.2

Internal rate of return (IRR)
This is the discount rate that will discount the cash flows to a net present value of zero. In
other words the present value of cash flows minus the initial investment equals a zero
NPV. The IRR therefore indicates what a particular project is expected to earn. A project
must only be considered if the IRR exceeds the cost of capital. The advantage of the IRR
method is that it considers the time value of money and is therefore more realistic than the
accounting rate of return (ARR). However, the calculation can be difficult especially when
the cash flows are not even.

4.
4.1
What is the relationship among sales, production and purchases budgets?

4.2

Your friend, who works for a company selling household appliances, recently told you that
she finds it amazing that the company seems to forecast sales each year so well. She cannot
explain how it is able to do it. Outline to your friend some factors that the management of
her company may have taken into account to forecast sales.

4.3

It is said that the forecast of operating activities is the key to the entire budget.
Explain why this is so.


4.4

Study the debtors collection schedule, cash budget and additional information for MVN
Enterprises for the period 01 April 20.6 to 30 June 20.6 and answer the questions that
follow.

Debtors collection schedule

Month

Credit
sales
R

April
R

May
R

June
R
February
March
April
May
208 000
320 000
336 000
304 000
41 600
256 000
-
-
-
64 000
268 800
-
-
-
67 200
?
297 600 332 800 ?

Cash budget for the period 01 April to 30 June 20.6
April May June
Cash receipts ? ? ?
Cash sales
Receipts from debtors
Loan
84 000
?
-
?
?
-
72 000
?
60 000

Cash payments (309 400) (300 200) (284 500)
Cash purchases of merchandise
Payments to creditors for merchandise
Rent
Selling and administrative costs
Other expenses
Interest on loan
50 400
112 000
20 000
105 000
22 000
-
45 600
117 600
20 000
95 000
22 000
-
43 200
106 400
22 000
90 000
22 000
900

Cash surplus (shortfall) ? ? ?
Opening cash balance 4 000 ? ?
Closing cash balance ? ? ?

Additional information
Cash sales account for 20% of total sales.
Thirty percent (30%) of all purchases are for cash
Creditors are paid in full in the month after the purchase of merchandise.

QUESTIONS
4.4.1 Calculate the expected cash sales for May 20.6.
4.4.2 Fill in the other missing amounts (indicated by?) in the debtors collection schedule and
cash budget.
4.4.3
4.4.3.1
4.4.3.2
Calculate the amount of credit sales that is expected to be collected after:
one month.
two months.
4.4.4 Debtors are granted credit terms of 30 days. Comment on the collections from debtors.
4.4.5 A cheque for the loan is expected to be received on 01 June 20.6. Calculate the interest
rate on the loan if interest is paid monthly.
4.4.6 Calculate the expected total purchases of merchandise for May 20.6.
4.4.7 By what percentage is the rent expected to increase by in June?
4.4.8 What could be the reason for the loan?
4.4.9 Comment on the cash position of the entity for the budget period.

4.5

PC Solutions makes and sells computers. On 31 March 20.6, the entity had 60 computers in
inventory. The companys policy is to maintain a computer inventory of 5% of the
following months sales. The sales forecast of the entity for second quarter of the year is:
April 1 200 computers
May 1 000 computers
June 900 computers
Required
What is the projected production for May?

4.6

The standard cost of material of product C for the third quarter of 20.6 was:
4 kg per unit at R3 per kg
45 000 kg of material was purchased at R2,80 for the third quarter.
The actual production of product C for the third quarter of 20.6 was:
9 000 units which took 37 000 kg of material
Required
Calculate the following variances:
4.6.1 Raw material price variance
4.6.2 Raw material usage variance
4.6.3 What are the most likely reasons for the price and usage variances? Who should be held
responsible?

4.7 Details relating to labour in the production department of AMI Ltd are as follows:
Standard labour cost
Actual hours worked and rate
Number of units manufactured
1,25 hours per unit at R5,50 per hour
600 hours @ R5,25 per hour
450

Required
4.7.1 Calculate the direct labour rate variance
4.7.2 Calculate the direct labour efficiency variance
4.7.3 What are the most likely reasons for the direct labour rate and efficiency variances?
Who should be held responsible?

4.8 The budgeted figures of GHI Manufacturers for August 20.6 are as follows:
Variable overheads
Fixed overheads
Number of labour hours
Standard time to manufacture one product
R49 000
R60 025
24 500
12

hours
The actual results are as follows:
Variable overheads
Fixed overheads
Number of labour hours worked
Units manufactured

R50 652
R60 300
24 120
2 000

4.8.1
Required
Calculate the following variances:
4.8.2 Variable overhead spending variance
4.8.3 Fixed overhead spending variance
4.8.4 Fixed overhead volume variance

4.9

What are some factors you would consider when accepting a special sales offer at a price
below cost?


4.10

Compu Limited has been purchasing carrying cases for its laptop computers at a delivered
cost of R102 each. The company, which is presently operating below full capacity, charges
factory overhead to production at the rate of 40% of direct labour cost. The fully absorbed
unit costs to produce similar carrying cases are expected to be:
Direct materials
Direct labour
Factory overhead (40% of direct labour)
R40
R48
R19,20
Total cost per unit R107,20

If Compu Limited manufactures the carrying cases, fixed factory overheads will not
increase and variable overhead costs associated with the cases are expected to be 25% of
the direct labour costs.

Required
Would it be advisable to make the carry cases or to continue buying them?
Support your answer by doing the necessary calculations.

4.11

Pegasus Limited expects to operate at 85% of productive capacity during June. The total
manufacturing costs for May for the production of 20 000 calculators are budgeted as
follows:
Direct materials
Direct labour
Variable factory overhead
Fixed factory overhead
R220 000
R90 000
R30 000
R70 000
Total manufacturing costs R410 000

The company has the opportunity to bid for 1 000 calculators to be delivered by 30 June to
a government agency. If the contract is obtained, selling and administrative expenses will
not increase. What is the unit cost below which Pegasus Limited should not go in bidding
on the government contract?


4.12

MG Motors intend investing in a new wheel alignment machine. The following details
relating to the machine apply:
Cost of machine
Expected useful life
Scrap value
Method of depreciation
Cost of capital
R60 000
5 years
R15 000
Straight-line
12%

Year
1
2
3
4
5
Cash flow
R10 000
R12 000
R28 000
R20 000
R45 000
Profit
R 1 000
R3 000
R19 000
R11 000
R21 000
Discount factor (12%)
0,8929
0,7972
0,7118
0,6355
0,5674

4.12.1
4.12.2
4.12.3

Required:
Calculate the payback period
Calculate the net present value (NPV). Should MG Motors invest in the new machine?
Calculate the accounting rate of return (ARR). Is this return favourable to MG Motors?

SOLUTIONS

? THINK POINT 1
* If the budgeting process did not encourage participation, managers on a lower level and
staff may feel disinclined to work to budget.
* Setting unrealistic targets may demotivate staff.
* Some managers may spend every cent of the budget allowance even though the spending
might be unnecessary.
* Those involved in the budgeting process may set low targets for achievement for
themselves.



? THINK POINT 2
* Managers usually dont have the time to investigate every deviation from budget.
* They should rather focus on significant differences.
* This allows managers to focus their energies on where they are needed and where they
are likely to make a difference.

4.1

Taken together, the sales, production and material purchases budgets represent the
operation component of the master budget. From the sales budget, managers develop the
production budget and in turn the material purchases budget. In this way, information and
estimates flow through the three schedules that all link together.

4.2

* The starting point is usually the current years level of sales.
Other factors include:
* Historical data e.g. sales trends of the company, competitors and industry.
* Economic trends e.g. inflation rates, interest rates.
* Anticipated changes in both purchasing costs and sales prices.
* Future marketing plans.
* Impact of new products on the product line.

4.3

The level of planned operating activity determines the quantity the products needed to fulfil
the plan, and this in turn has an influence on the level of operating expenses and other costs
that will be incurred as well as the level of cash and other resources that will be needed to
support the fulfilment of the plan.


4.4.1

Cash sales = 20% of total sales.
Credit sales for May = R304 000 (80% of total sales)
Cash sales = R304 000 X 20 = R76 000
80
OR
Credit sales = R304 000
Therefore: Total sales = R304 000 X 100
80
= R380 000
Therefore: Cash sales = R380 000 R304 000
= R76 000
4.4.2 Debtors collection schedule

Month

Credit
sales
R

April
R

May
R

June
R
February
March
April
May
208 000
320 000
336 000
304 000
41 600
256 000
-
-
-
64 000
268 800
-
-
-
67 200
243 200
297 600 332 800 310 400

Cash budget for the period 01 April to 30 June 20.6
April May June
Cash receipts 381 600 408 800 442 400
Cash sales
Receipts from debtors
Loan
84 000
297 600
-
76 000
332 800
-
72 000
310 400
60 000

Cash payments (309 400) (300 200) (284 500)
Cash purchases of merchandise
Payments to creditors for merchandise
Rent
Selling and administrative costs
Other expenses
Interest on loan
50 400
112 000
20 000
105 000
22 000
-
45 600
117 600
20 000
95 000
22 000
-
43 200
106 400
22 000
90 000
22 000
900

Cash surplus (shortfall) 72 200 108 600 157 900
Opening cash balance 4 000 76 200 184 800
Closing cash balance 76 200 184 800 342 700


4.4.3.1

4.4.3.2
Using the credit sales for March (R320 000):
R256 000 R320 000 X 100 = 80% (collected after one month)
R64 000 R320 000 X 100 = 20% (collected after two months)

4.4.4

80% of debtors settle their accounts on time. The remaining 20% exceed their credit terms
by paying one month later than they supposed to. The business does not expect any bad
debts.

4.4.5
R900 X 12 X 100 = 18%
R60 000

4.4.6

Cash purchases for May
Credit purchases for May
R45 600
R106 400

R152 000

4.4.7 R2 000 R20 000 X 100 = 10%

4.4.8

The entity probably intends expanding and may therefore need the funds (together with the
cash generated from operations) for purchase of assets such as machinery and equipment.

4.4.9

The entity expects to generate enough cash each month to meet its payments. A cash
surplus is thus expected each month. Since the bank balance is expected to be favourable
each month, it does not need overdraft facilities during the budget period. The cash position
is good.

4.5 Apr May
Sales forecast (in units)
Desired closing inventory of finished goods
1 200
50
1 000
45
Total budgeted production needs
Opening inventory of finished goods
1250
(60)
1 045
(50)
Required production 1 190 995
Projected production for August is 995 computers.


4.6.1

Raw material price variance
= (Actual price Standard price) X Actual quantity issued
= (R2,80 R3,00) X 37 000
= R7 400 (favourable)

4.6.2

Raw material usage variance
= (Actual quantity Standard quantity) X Standard price
= (37 000 36 000) X R3
= R3 000 (unfavourable)

Note: Standard quantity = 9 000 X 4 kg = 36 000 kg

4.6.3

The purchasing department is responsible for any raw material price variance that may
arise. It may be due to incorrect calculation of discounts and delivery costs. However,
material price variances may be the result of mistakes made when the standard price was set
and unexpected price changes.

The production department is also responsible for any raw material usage variances that
might occur. It may be due to poor control over materials. However, variances may be due
to faulty standards and changes in the quality of the material supplied.

4.7.1

Direct labour rate variance
= (Actual rate Standard rate) X Actual hours worked
= (R5,25 R5,50) X 600
= R150 (favourable)

4.7.2

Direct labour efficiency variance
= (Actual time worked Standard time allowed) X Standard rate
= (600 562,5) X R5,50
= R206,25 (unfavourable)
Note:
Standard time allowed = 450 units X 1,25 hours per unit
= 562,5 hours


4.7.3

The personnel manager will usually be responsible for this variance. However the
variance could be ascribed to change to wage rates, unscheduled overtime, use of lower
skilled workers with lower pay etc.

The manager responsible for the supervision of labour is usually responsible for this
variance. However this variance may be due to the quality of supervision, skill of
employees, interruptions in production etc.

4.8.1

= (Actual hours Standard hours allowed) X Standard rate
= (24 120 [2 000 X 12]) X (49 000 24 500)
= (24 120 24 000) X R2,00
= 120 X R2,00
= R240 (unfavourable)

4.8.2

Variable overhead spending variance
= (Actual rate Standard rate) X Actual hours
= ([50 652 24 120] R2,00) X 24 120
= (R2,10 R2,00) X 24 120

4.8.3 Fixed overhead spending variance
= Actual fixed overheads Budgeted fixed overheads
= R60 300 R60 025
= R275 (unfavourable)

4.8.4 Fixed overhead volume variance
= Budgeted fixed overheads Standard fixed overheads
= R60 025 (2 000 X 12 X R2,45)
= R60 025 R58 800
Note:
Standard fixed overheads = Number of units produced X Standard time to make 1 product
X Standard rate per hour
Standard rate per hour = Standard fixed overheads standard number of labour hours
= R60 025 24 500
= R2,45

4.9

* Production capacity must be available.
* Fixed costs must remain unchanged.
* The price offered must be more than the relevant costs that would be incurred if the offer
is accepted.
*The current selling prices per unit must not be affected by the acceptance of the special
offer.

4.10 Direct materials
Direct labour
Variable factory overhead costs (25% of direct labour)
R40
R48
R12
If there are no unfavourable factors affecting the decision, Compu Limited would be
advised to manufacture the cases as there would be a saving of R2 per case.

4.11

The relevant costs are the variable costs. It should not sell below the variable costs per unit
of R17 which is calculated below. Any selling price above this amount will result in a
positive contribution margin.

20 000 units
Total (R) Per unit (R)
Direct materials
Direct labour
Variable overhead costs
220 000
90 000
30 000

Total variable costs 340 000 R17

4.12.1 Investment (R60 000)
Year 1 Cash flow R10 000
(R50 000)
(R38 000)
(R10 000)
Payback period is 3 years 6 months
Note:
R10 000 X 12 mths
R20 000
= 6 months

4.12.2
Year Cash inflow Discount
Factor
Present
value

1
2
3
4
5
5 (scrap value)
Total PV
Investment
NPV (positive)
R10 000
R12 000
R28 000
R20 000
R30 000
R15 000

0,8929
0.7972
0,7118
0,6355
0.5674
0.5674

R8 929
R9 566
R19 930
R12 710
*R17 022
* R8 511
R76 668
(R60 000)
R16 668

* Alternative: Year 5 45 000 X 0,5674 = R25 533
Since the net present value is positive, the machine should be purchased.

4.12.3 Accounting rate of return:

Average annual profit X 100 =
Average investment 1
Machine X

R11 000 X 100
R37 500 1

= 29,33%
Note:
Average annual profit =
R1 000 + R3 000 + R19 000 + R11 000 + R21 000
5 years
= R11 000 p.a.
Average investment = Cost of machine + Disposal value
2

= R60 000 + R15 000
2
= R37 500

Since the accounting rate of return (29,33%) is greater than the cost of capital (12%), the
return is favourable and the machine should be purchased.


TOPIC 8
TRANSFER PRICING FOR DECENTRALISED ENTERPRISES

LEARNING OUTCOMES
be familiar with the purposes of transfer pricing.
describe the various transfer pricing methods.
explain the tax implication when setting transfer prices for multinational transactions.


CONTENTS

1. What is transfer pricing?
2. Purposes of transfer pricing
3. Transfer pricing methods
4. International transfer pricing

READING
Recommended
Atrill P and Mc Laney E (2002) Management Accounting for Non-specialists, Third edition,
Pearson Education Limited: Essex. (Chapter 10)

Drury C. (2005) Management Accounting for Business, Third edition, Thomson Learning: London
(Chapter 14)

Decisions, Third edition, Thomson South-Western: Canada. (Chapter M10)

Management Accounting, Fifth edition, LexisNexis Butterworths: Durban. (Chapter 14)

(Chapter 14)


1.

WHAT IS TRANSFER PRICING?
Transfer pricing involves determining appropriate selling prices for goods or services when
both the buyer and the seller are within the same entity. Transfer pricing thus arise within
decentralised enterprises. When an enterprise has many divisions, it often happens that one
division buys products from another division. Since internal transfer prices will affect
revenues (for the selling division) and costs (for the buying division), an enterprises
transfer pricing policies will influence each divisions return on investment. Since
divisional managers are often assessed by the profits generated by their divisions, setting
transfer prices may be a sensitive issue to divisional managers.

? THINK POINT 1
What would be some implications of divisional competition and performance evaluation on
the setting of transfer prices?

2.

PURPOSES OF TRANSFER PRICING
Transfer pricing seeks to attain the following:
Optimise the profits for the enterprise as a whole.
Encourage the autonomy of individual divisions.
Provide information to evaluate the performance of divisions.
Move profits between divisions or locations.

3.

TRANSFER PRICING METHODS
The general methods for determining transfer prices are as follows:
Market-based transfer prices
Variable cost transfer prices
Full cost transfer prices
Cost-plus a mark-up transfer price
Negotiated transfer price


3.1

Market-based transfer prices
These are the actual prices that the supplying division sells the product to external clients
for or they may the prices a competitor is offering. If a perfectly competitive market exists,
the current market price is the most suitable basis for setting the transfer price. A perfectly
competitive market is one where the product is homogeneous and no single buyer or seller
can affect market prices. In this kind of market, there is little interdependence between
divisions. The supply of transfer goods at market prices usually results in optimal profits
for the entire enterprise.

In a perfectly competitive market, the supplying division should supply as much as is
required by the receiving division at the current market price. If the receiving divisions
demand is greater then the supplying division can meet, additional supplies must be
obtained from an outside supplier at market price.

If the supplying division cannot sustain a profit in the long term at the current outside
market price, then the enterprise will be better off not producing the product internally. It
should rather purchase from outside suppliers

? THINK POINT 2
If the receiving division cannot make a profit in the long term when transfers are made at
the current market price, what should the enterprise do?

One of the major problems of using market prices is that it is unlikely that the market will
be perfectly competitive. Also, the product being transferred may have certain
characteristics that differentiate it from other varieties of the same product. Sometimes it
may be possible that external suppliers may be selling at a temporary discounted price that
is below the total cost but above the variable cost. If the supplying division has excess
capacity, incorrect decisions may be taken if the market price rule is strictly adhered to.
For example, suppose the supplying division has spare capacity to produce the (transfer)
product at a variable cost of R500 and the transfer price is set at the external market price of
R800. If an external supplier is selling at a temporary discounted price of R750, the
manager of the receiving division will be tempted to purchase from the external supplier at

R750 instead of R800 (transfer price). However, since the supplying division has spare
capacity and the relevant cost of making the product is R500, adhering strictly to the market
price rule can cause managers to make decisions that are not in the best interests of the
enterprise.

3.2

Variable cost transfer prices
When the supplying division is operating below capacity, variable cost transfer prices can
motivate both the supplying and receiving divisions to operate at levels of output that will
maximize the profit of the enterprise as a whole. In this case the opportunity cost to the
supplying division is not the market price since it does not have to give up selling in the
market to enable it to supply its fellow division. There is capacity to do both. In these
circumstances the opportunity cost is equal to the variable cost of producing the product.
Using variable cost as a basis for determining transfer prices is an acceptable approach in
the short term.

The biggest problem with this method is that the receiving division will generate a profit at
the expense of the supplying division. Quite often supplying divisions are reluctant to
transfer their products at variable costs. Another problem is that variable cost per unit may
not be constant over the entire range of output as increases may occur. Where the division
is operating at full capacity, variable cost transfers will mean that inter-divisional sales will
be less profitable than sales to external customers.

3.3

Full cost transfer prices
This method is widely used. Full costs include all production and costs of other business
functions including marketing, distribution, administrative, research and development. This
method is preferable to variable cost transfers for evaluation purposes since the supplying
division can recover the full cost of production.

The main problem with this method is that the supplying division will gain no profit from
the transfer and thus does not provide an incentive to the supplying division to transfer
goods internally. If internal transfers comprise a significant part of the supplying divisions
business, its profits will be understated.


3.4

Cost-plus a mark-up transfer price
This method attempts to enable supplying divisions to obtain a profit on the goods
transferred. This places the division on a good footing for performance evaluation. A mark-
up may be added to the full cost to provide a profit margin for the supplying division. In
other cases the mark-up is added to the variable cost and is intended to cover both fixed
costs and profit contribution.

Problems arise when the method is applied to transfers beyond two divisions. If the first
division transfers goods to the second division at cost plus 15%, and the goods received
from the second division are further processed and transferred at cost plus 15% to the next
division, and so on, then the percentage margin becomes very great by the time the mark-up
is added by the last division in the process.

3.5

Negotiated transfer price
As a result of the difficulties experienced with the methods described above, negotiated
transfers have been suggested. Negotiated transfer prices are appropriate when there are
market imperfections for the product. In these cases, divisional managers must have the
freedom to buy and sell outside the enterprise to enable them to engage in the bargaining
process.

If divisions are free to bargain with each other, they will usually make decisions that will
maximize the profits of the enterprise. It is important for managers to have equal bargaining
power for negotiations to be effective. Where there is a perfect market situation for the
product, the external market price is still preferable to negotiated transfer prices.

Negotiated transfer pricing has some disadvantages. The agreed transfer price depends on
the negotiating skills and bargaining power of the managers involved. Also, conflicts may
arise between divisions. The process can also be time-consuming for the managers involved
especially when a large number of transactions are involved.


4.

INTERNATIONAL TRANSFER PRICING
The concern here is with prices that an enterprise uses to transfer products between
divisions in different countries. The rise of multinational enterprises brings about a further
issue to be considered when setting transfer prices viz. the effect of taxation.

If tax rates differ significantly between countries, setting a transfer price that allows the
enterprise to allocate most of its profit in the county with the lowest tax rate would be wise.
Suppose an enterprise manufactures products in country X that has a marginal tax rate of
30% and it sell those products to its division in country Y that has a marginal tax rate of
42%. The enterprise will benefit more if it locates most of its profit in country X that has
the lower tax rate. The enterprise will therefore want to use the highest possible transfer
price so that the receiving division in country Y will have higher costs and report lower
profits. On the other hand the supplying division in country X will earn higher revenues and
earn higher profits.

With multinational enterprises the main issue with setting transfer prices is minimization of
global taxes. However taxation authorities in most countries are aware of intentions of
many multinational enterprises to manipulate profits declared in various countries. They
investigate transfer pricing methods to combat tax avoidance. For this reason many
multinational enterprises use the same transfer pricing method for both domestic and
international transfers.

5.
5.1

If there is a perfectly competitive market, explain why the correct transfer price should be
the external market price.

5.2 Explain some problems that may arise from using market price as the transfer price
between divisions.

5.3

Where a perfectly competitive market exists, the effect of selling expenses will be different
on the enterprises profits if the product is acquired internally compared to externally.
Explain why.

5.4

Describe the use of and problems associated with transfer prices based on variable cost and
full cost.

5.5

The head office of the division you are working for prescribes that the full cost transfer
price method be used for transfers between its divisions. Recommend to head office and
motivate for an alternative to using the actual cost for transfers between divisions (whilst
still using the full cost transfer method).

5.6

When using the negotiated transfer price approach, within what range would you
recommend the transfer price be established? Explain why.

5.7

Verda Limted has an operating division that produces toasters. The toasters are normally
sold to customers at R75 each. The division is presently producing 4 000 toasters per month
(which is about 60% capacity) and has the following cost structure:

Variable cost
Fixed cost apportionment
Unit cost
R35
R15

Another division of the company has offered to buy 1 500 toasters at R45 each. How would
you respond to the offer if you were the manager of the supplying division?

SOLUTIONS

? THINK POINT 1
The use of performance indicators like return on investment may encourage managers to
make decisions that benefit their divisions but at the same time adversely affect the overall
enterprise. In order to increase return on investment for their respective divisions, the
selling division will try to receive the highest possible price while the buying division will
try to pay the lowest possible price.

? THINK POINT 2
It should stop making the product, and the supplying division should sell its output to the
external market.

5.1

If the supplying division did not exist, the product will have to be purchased at the current
market price from external suppliers. Other the other hand, if the receiving division did not
exist, the product will have to be sold at current market price to the outside market.
Divisional profits will thus be similar if the divisions were separate organisations.

5.2

*The market price may not be the best option if the supplying division is operating below
capacity (a price between the variable cost per unit and market price can be negotiated).
* The supplying division may make savings since selling and distribution costs may be
lower. These savings could be passed on to the receiving division in the form of lower
prices.
* There may not be a potential external customer for the product as it may be specific to the
needs of the division it manufactures for.

5.3

The supplying division will incur selling expenses when selling to the outside market but
these selling expenses may not be incurred in inter-divisional transfers (resulting in a saving
for the enterprise). If the receiving division purchases the product externally, the enterprise
will be worse off to the extent of the selling expenses incurred by the supplying division in
selling to the outside market.

5.4

The variable cost method is useful when the supplying division is operating below
capacity. However, when the supplying division is operating at full capacity and external
customers are prepared to pay more than the variable cost of the goods, a variable cost
internal transfer price will result in inter-divisional sales being less profitable than sales to
the external market. There is thus no incentive to managers of the supplying division to
agree to a variable cost transfer price.

The full cost method is preferable to variable cost transfers for evaluation purposes since
the supplying division can recover the full cost of production. However this approach does
not provide any real incentive to the divisional managers to keep costs down, since they can
pass the costs on to the receiving division. The result is that operating inefficiencies of the
supplying division will be transferred to the receiving division.

5.5

Standard costs (an estimate of what products should cost) may be used instead of actual
costs. In this way differences between actual costs and standard costs remain with the
supplying division for cost control purposes.

5.6

The negotiated price should be no less than the variable cost per unit and no greater than the
market price per unit. In a perfectly competitive market, there is little interdependence
between divisions. The supply of transfer goods at market prices usually results in optimal
profits for the entire enterprise.
When the supplying division has excess capacity, the opportunity cost to the supplying
division is not the market price since it does not have to give up selling in the market to
enable it to supply its fellow division. There is capacity to do both. In these circumstances
the opportunity cost is equal to the variable cost of producing the product.

5.7

Since the division is operating below capacity, the market-based transfer price may be
inappropriate as it would lead to lost sales. The other division may buy from external
sources and the loss in sales will not be made good by sales to outside customers. It would
be better to base the transfer price on the variable cost of the goods as this would represent
the relevant cost of increased production when there is excess capacity. The transfer price
could therefore be somewhere between R35 and R75.


TOPIC 9
CORPORATE GOVERNANCE

LEARNING OUTCOMES
explain the reasons for establishment of corporate governance systems.
describe why corporate governance is important.
outline the role of audit and independent auditors.
explain the responsibility of directors to the shareholders and the public in general.
recognise the implications for directors of fraudulent and wrongful trading.


CONTENTS

1. Background to the emergence of corporate governance
2. Definition of corporate governance
3. Corporate governance code of practice
4. Audit and the role of auditors
5. Responsibilities of directors
6. Directors remuneration
7. Insolvency
8. Wrongful trading and fraudulent trading

READING
Recommended
(Chapter 7)

Hand L., Isaaks C. and Sanderson P (2005) Introduction to Accounting for Non-Specialists, First
edition, Thomson Learning: London. (Chapter 11)

Press Southern Africa: Cape Town. (Chapter 1)

(Chapter 32)


1.

BACKGROUND TO THE EMERGENCE OF CORPORATE GOVERNANCE
In recent times a number of financial scandals have been reported in the media e.g. Enron,
Global Crossing, SA Post Office. It is not uncommon for executives and directors to misuse
company assets for their own use. Although it is the shareholders who own the company, it
is difficult for them to monitor the actions of directors and call them to account.

Following the financial scandals and company failures in the 1980s and 1990s there was a
lack in confidence in financial reporting. Furthermore shareholders and other stakeholders
could not depend on auditors to provide the necessary safeguards to rely on company
annual reports.

? THINK POINT 1
What do you think were the main factors that contributed to the lack of confidence in
financial reporting?

John Sullivan, the executive director of the Centre for Private Enterprise, said the following
in his keynote speech (2006) to the US Chamber of Commerce which was attended by the
Institute of Directors:
The dilemma in corruption is that though its bad for business, individual companies that
engage in the practice receive a short-term advantage. Therefore, it is important to establish
a system that makes it hard for companies to be corrupt. Corporate governance is one of the
antidotes. If governance is effective, it is hard for companies to offer bribes or other
company resources to government officials.

Committees were set up in different countries to address the concerns of financial
corruption and company failure and to make recommendations on good practice. In South
Africa, the Institute of Directors assigned this task to the King Commission that published
two reports (called King Reports) on corporate governance in 1994 and 2002. In the UK, it
was the Cadbury Committee that was given the task.


2.

DEFINITION OF CORPORATE GOVERNANCE
Corporate governance is concerned with how a company should be controlled and managed
in the best interests of all its stakeholders. The concern is also with whether a company
attains its objectives in a socially responsible manner.

3.
3.1

CORPORATE GOVERNANCE CODE OF PRACTICE
The King Reports
The King Reports spells out the controls and disclosures that a company should comply
with to protect the various stakeholders. The governance controls included in the report are:
directors are to be appointed by a committee and their contracts should not extend to more
than three years.
directors remuneration should be based on performance and decided on by a remuneration
committee (that excludes executive directors who are involved in the management of the
company).
there should be an internal audit function that reports directly to the Board of Directors.

The King Reports also sets out disclosure requirements i.e. information that is required in a
companys annual report. These disclosure requirements include:
disclosure of the companys economic empowerment policies and practices.
disclosure of the companys HIV/Aids strategy, policies and practices.
disclosure of the social and environmental impact of the company, including policies and
practices to address these concerns.

All private and public companies are encouraged to comply with the King reports. Listed
companies are required to disclose the extent of their compliance to the second King report,
providing reasons for any failures to comply. These companies face penalties if they fail to
provide this information.


3.2

Combined Code of Practice
The Combined Code of Practice (UK) provides a framework for corporate governance and
accountability and it was a result of work done by the Cadbury Committee and Greenbury
Committee.

The main elements of the code are:
3.2.1 The board of directors: Boards should be properly constituted and there should be
adequate separation of duties. The board should have at least one-third of its membership as
independent non-executive directors who can give impartial advice. Directors should re-
submit themselves for re-election every three years. Directors should not be involved in
determining their own remuneration and terms of service.
3.2.2 Relationship with shareholders: The code lays down good practice for communication
between the board and shareholders. Shareholders must be given the chance to question
directors on the conduct of the companys business at the annual general meeting of the
company.
3.2.3 Accountability and audit: Directors and auditors are required to provide a written
explanation of their responsibilities in producing the financial reports. The directors must
confirm that the business is a going concern, giving any qualification they think is
appropriate.
3.2.4 Internal control: Directors are required to regularly check that they have effective systems
of internal control that cover financial, operational and risk management of the business.
3.2.5 Audit committees: Besides the necessity of having external auditors, the code recommends
the establishment of a company audit committee that includes three non-executive directors
to oversee the audit and to ensure that the auditors are independent and objective in
carrying out their functions.

Since corporate governance has a lot to do with audit and directors, a greater discussion
about these follow.


4.

AUDIT AND THE ROLE OF AUDITORS
The external auditors are not part of the company but their responsibility is to the
shareholders. Their main duty is to objectively report to shareholders and others as to
whether, in their opinion, the financial statements can be relied upon and whether they
comply with statutory, regulatory and accounting standard requirements.

Sometimes financial statements may be affected by an inherent, and fundamental
uncertainty. If there is inadequate disclosure about the fundamental uncertainty then the
auditors may give what is called a qualified opinion and the audit report is described as a
qualified audit report.

? THINK POINT 2
What could be possible consequences of a qualified audit report to a company?

The role of auditors has been subject to criticism over the years because their
responsibilities do not include providing guarantees that the financial statements are
correct, that the company will not fail and that there has been no fraud. An area of risk that
is of great concern to companies is fraud. Since this is not currently required from an
external audit, it is something that the internal audit committee should be responsible for.
The internal audit must aim to detect fraud and try to minimise or eliminate it.

5.

RESPONSIBILITIES OF DIRECTORS
Directors are expected to use their common sense, be careful in what they do and look after
shareholders, employees and creditors. They must always act in the best interests of the
company without acting for their personal benefit. They must carry out their duties with the
skill and care that someone with the necessary knowledge and experience would exercise if
they were acting on their own behalf. Directors must act honestly and in good faith.


6.

DIRECTORS REMUNERATION
Executive directors should not play any part in decisions about their own remuneration.
Boards should appoint remuneration committees consisting of mainly or all independent
non-executive directors. The remuneration committee will determine the companys policy
on executive remuneration including pension rights and any compensation payments. The
members of the committee should be listed in the committees report to shareholders each
year. The chairperson of this committee must attend the companys annual general meeting
(AGM) to answer questions about directors remuneration. A resolution is then voted on at
the AGM to approve the remuneration package proposed to directors.

7.

INSOLVENCY
A company becomes insolvent when it is unable to pay creditors debts in full if all the
assets of the company are realised. Directors who allow a company to trade while insolvent
may be disqualified and may also incur personal liability. If a company becomes insolvent
courts assess the directors responsibility for:
the cause of the insolvency;
any failure to supply goods that have been paid for; and
entering into any fraudulent transactions.

8.

WRONGFUL TRADING AND FRAUDULENT TRADING
Wrongful trading arises when a director knows or ought to have known before the
commencement of winding up that there was no reasonable chance of the company
avoiding insolvency and that he/she did not take steps to minimise losses to creditors. Such
a person may be ordered by the court to contribute to the assets of the company and the
person would also be disqualified from any further involvement in corporate management
for a specified period of time.

Fraudulent trading occurs when a person is knowingly party to the company incurring
more debts at a time when it is known that these debts will not be honoured, or for any
other fraudulent purposes (which could take place at any time). Persons acting in this
manner may be held liable, without limitation, for the debts of the company. This kind of
offence usually carries criminal penalties.


9.
9.1

In a study of outstandingly successful businesses and companies that failed, it was found
that strategic factors were considered to be more important than good corporate
governance. What are your views on this?

9.2

At the Global Economic Governance Forum (2006), one of the speakers said that directors
should be trusted to act with integrity. What do you think?

9.3

Name some of the basic problems that shareholders with small shareholdings encounter as
they enter a new relationship with the company that they effectively partly own.

9.4 Name some factors that you think has increased the incidence of fraud in recent times.

9.5 To whom are auditors responsible and for what?

9.6 Why do you think it may become necessary to bar a person from becoming a director of a
company?

9.7

Use the following information from the annual company report of Thompsons Limited (a
multi-national company) as a basis for discussing the users of financial informations need
for information on directors remuneration.

T. Blair (Executive director)
Basic salary
R1 500 000
Bonuses
R450 000
Benefits in kind
R50 000
C. Ramaphosa (Non- Executive director) R90 000 Nil Nil
G. Bush (Non- Executive director) None of the above but has a US $ R200 000
consultancy agreement.

9.8 Why should there be openness regarding directors benefits and perks?

9.9

The King Report states directors contracts should not extend to more than three years and
that they should no longer be open-ended. Why do you think that the investigation came up
with this recommendation?


SOLUTIONS

? THINK POINT 1
* Loose accounting standards that allow a lot of latitude e.g. the treatment of extraordinary
items in financial reporting.
* Directors did not operate within a clear framework to regularly review business controls.
* Inability of auditors to maintain independence from boards of directors.
* Lack of accountability with regard to directors remuneration.

? THINK POINT 2
A qualified audit report can destroy the credibility of a company. It can also create
uncertainty. It will impact negatively on market share price. A qualified report is definitely
something that should be avoided.

9.1

It must be remembered that poor corporate governance can ruin a company. On the other
hand, good corporate governance, on its own, cannot ensure success. This implies that a
combination of strategic factors and good corporate governance are requirements for
success.

9.2

Numerous incidents of fraud and negligence on the part of directors require some form of
control and this can be achieve through the application of effective corporate governance.
Many directors have been found to be:
* guilty of breaches of company legislation.
* unfit to run a company.
* negligent in carrying out their duties.
* engaged in fraudulent or wrongful trading.
* convicted of some indictable offence.


9.3

Within a short time of acquiring their shares, most new small shareholders realise that they
have neither the influence nor power to make a difference. As the company expands, the
directors become more distanced from the shareholders. During the period towards
expansion questions about accountability often start to develop.

9.4

* Increasing pace of change
* Unavoidable use of computer systems.
* Ease and speed of the electronic transfer of funds.
* Use of the internet.
* Increasing dependence on specific knowledge e.g. information technology (IT).

9.5

Auditors are responsible to the shareholders.
Their main duty is to report objectively to shareholders and others as to whether, in their
opinion, the financial statements show a true and fair view and whether they comply with
statutory, regulatory and accounting standard requirements.

9.6

* Unscrupulous persons may cause innocent people to lose their money.
* Many creditors may be left out of pocket through their actions.

9.7

Shareholders are the owners of the company and their dividends depend on the profit
earned by the company. These profits are affected by the for directors remuneration
expense. The remuneration of directors should take into account the difficulty in managing
a major multi-national company.

The executive director earns a salary of R1 500 000, an amount that shareholders will like
to see disclosed in the accounts and discussed at the AGM. The bonus of R450 000 will
also generate some interest amongst shareholders and institutions. Pressure will be exerted
on directors if they feel that the award is excessive. The consultancy agreement for a non-
executive director may also be of interest to the various users.

9.8

These benefits and perks affect the annual profit. Shareholders receive dividends from the
annual profit. Shareholders are required to approve of the accounts including the
remuneration of directors at the AGM. If directors conceal information regarding their
benefits and perks from the shareholders, then that part of the accounts may not show a true
and fair view of the situation.

9.9

Prior to the King Reports being accepted and the governance code introduced, directors had
powers that were increasing especially regarding length of contract. Newspapers report
regularly on compensation paid to directors, where the company performance was
acknowledged to be poor. There is usually a reference to the length of the outstanding
directors contract. Furthermore, shareholders can decide to buy or sell or hold shares if
they know in advance information on the type of contracts being awarded to directors of the
company.


TABLE 1

Table 1: Present value of R1: PVFA (k,n) =

Number
of
Periods

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

25%
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333 0.8000
2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264 0.8116 0.7972 0.7831 0.7695 0.7561 0.7432 0.7305 0.7182 0.7062 0.6944 0.6400
3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513 0.7312 0.7118 0.6931 0.6750 0.6575 0.6407 0.6244 0.6086 0.5934 0.5787 0.5120
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830 0.6587 0.6355 0.6133 0.5921 0.5718 0.5523 0.5337 0.5158 0.4987 0.4823 0.4096
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209 0.5935 0.5674 0.5428 0.5194 0.4972 0.4761 0.4561 0.4371 0.4190 0.4019 0.3277

6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645 0.5346 0.5066 0.4803 0.4556 0.4323 0.4104 0.3898 0.3704 0.3521 0.3349 0.2621
7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835 0.5470 0.5132 0.4817 0.4523 0.4251 0.3996 0.3759 0.3538 0.3332 0.3139 0.2959 0.2791 0.2097
8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820 0.5403 0.5019 0.4665 0.4339 0.4039 0.3762 0.3506 0.3269 0.3050 0.2848 0.2660 0.2487 0.2326 0.1678
9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241 0.3909 0.3606 0.3329 0.3075 0.2843 0.2630 0.2434 0.2255 0.2090 0.1938 0.1342
10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855 0.3522 0.3220 0.2946 0.2697 0.2472 0.2267 0.2080 0.1911 0.1756 0.1615 0.1074

11 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3875 0.3505 0.3173 0.2875 0.2607 0.2366 0.2149 0.1954 0.1778 0.1619 0.1476 0.1346 0.0859
12 0.8874 0.7885 0.7014 0.6246 0.5568 0.4970 0.4440 0.3971 0.3555 0.3186 0.2858 0.2567 0.2307 0.2076 0.1869 0.1685 0.1520 0.1372 0.1240 0.1122 0.0687
13 0.8787 0.7730 0.6810 0.6006 0.5303 0.4688 0.4150 0.3677 0.3262 0.2897 0.2575 0.2292 0.2042 0.1821 0.1625 0.1452 0.1299 0.1163 0.1042 0.0935 0.0550
14 0.8700 0.7579 0.6611 0.5775 0.5051 0.4423 0.3878 0.3405 0.2992 0.2633 0.2320 0.2046 0.1807 0.1597 0.1413 0.1252 0.1110 0.0985 0.0876 0.0779 0.0440
15 0.8613 0.7430 0.6419 0.5553 0.4810 0.4173 0.3624 0.3152 0.2745 0.2394 0.2090 0.1827 0.1599 0.1401 0.1229 0.1079 0.0949 0.0835 0.0736 0.0649 0.0352

16 0.8528 0.7284 0.6232 0.5339 0.4581 0.3936 0.3387 0.2919 0.2519 0.2176 0.1883 0.1631 0.1415 0.1229 0.1069 0.0930 0.0811 0.0708 0.0618 0.0541 0.0281
17 0.8444 0.7142 0.6050 0.5134 0.4363 0.3714 0.3166 0.2703 0.2311 0.1978 0.1696 0.1456 0.1252 0.1078 0.0929 0.0802 0.0693 0.0600 0.0520 0.0451 0.0225
18 0.8360 0.7002 0.5874 0.4936 0.4155 0.3503 0.2959 0.2502 0.2120 0.1799 0.1528 0.1300 0.1108 0.0946 0.0808 0.0691 0.0592 0.0508 0.0437 0.0376 0.0180
19 0.8277 0.6864 0.5703 0.4746 0.3957 0.3305 0.2765 0.2317 0.1945 0.1635 0.1377 0.1161 0.0981 0.0829 0.0703 0.0596 0.0506 0.0431 0.0367 0.0313 0.0144
20 0.8195 0.6730 0.5537 0.4564 0.3769 0.3118 0.2584 0.2145 0.1784 0.1486 0.1240 0.1037 0.0868 0.0728 0.0611 0.0514 0.0433 0.0365 0.0308 0.0261 0.0115

25 0.7798 0.6095 0.4776 0.3751 0.2953 0.2330 0.1842 0.1460 0.1160 0.0923 0.0736 0.0588 0.0471 0.0378 0.0304 0.0245 0.0197 0.0160 0.0129 0.0105 0.0038
30 0.7419 0.5521 0.4120 0.3083 0.2314 0.1741 0.1314 0.0994 0.0754 0.0573 0.0437 0.0334 0.0256 0.0196 0.0151 0.0116 0.0090 0.0070 0.0054 0.0042 0.0012
40 0.6717 0.4529 0.3066 0.2083 0.1420 0.0972 0.0668 0.0460 0.0318 0.0221 0.0154 0.0107 0.0075 0.0053 0.0037 0.0026 0.0019 0.0013 0.0010 0.0007 0.0001
50 0.6080 0.3715 0.2281 0.1407 0.0872 0.0543 0.0339 0.0213 0.0134 0.0085 0.0054 0.0035 0.0022 0.0014 0.0009 0.0006 0.0004 0.0003 0.0002 0.0001 *
60 0.5504 0.3048 0.1697 0.0951 0.0535 0.0303 0.0173 0.0099 0.0057 0.0033 0.0019 0.0011 0.0007 0.0004 0.0002 0.0001 0.0001 * * * *

TABLE 2

Table 2 : Present value of a regular annuity of R1 per period for n periods : PVFA (k,n) =

Number
of
Periods

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333
2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.8080 1.7833 1.7591 1.7355 1.7125 1.6901 1.6681 1.6467 1.6257 1.6052 1.5852 1.5656 1.5465 1.5278
3 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730 2.6243 2.5771 2.5313 2.4869 2.4437 2.4018 2.3612 2.3216 2.2832 2.2459 2.2096 2.1743 2.1399 2.1065
4 3.9020 3.8077 3.7171 3.6299 3.5460 3.4651 3.3872 3.3121 3.2397 3.1699 3.1024 3.0373 2.9745 2.9137 2.8550 2.7982 2.7432 2.6901 2.6386 2.5887
5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908 3.6959 3.6048 3.5172 3.4331 3.3522 3.2743 3.1993 3.1272 3.0576 2.9906

6 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173 4.7665 4.6229 4.4859 4.3553 4.2305 4.1114 3.9975 3.8887 3.7845 3.6847 3.5892 3.4976 3.4098 3.3255
7 6.7282 6.4720 6.2303 6.0021 5.7864 5.5824 5.3893 5.2064 5.0330 4.8684 4.7122 4.5638 4.4226 4.2883 4.1604 4.0386 3.9224 3.8115 3.7057 3.6046
8 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098 5.9713 5.7466 5.5348 5.3349 5.1461 4.9676 4.7988 4.6389 4.4873 4.3436 4.2072 4.0776 3.9544 3.8372
9 8.5660 8.1622 7.7861 7.4353 7.1078 6.8017 6.5152 6.2469 5.9952 5.7590 5.5370 5.3282 5.1317 4.9464 4.7716 4.6065 4.4506 4.3038 4.1633 4.0310
10 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601 7.0236 6.7101 6.4177 6.1446 5.8892 5.6502 5.4262 5.2161 5.0188 4.8332 4.6586 4.4941 4.3389 4.1925

11 10.3676 9.7868 9.2526 8.7605 8.3064 7.8869 7.4987 7.1390 6.8052 6.4951 6.2065 5.9377 5.6869 5.4527 5.2337 5.0286 4.8364 4.6560 4.4865 4.3271
12 11.2551 10.5753 9.9540 9.3851 8.8633 8.3838 7.9427 7.5361 7.1607 6.8137 6.4924 6.1944 5.9176 5.6603 5.4206 5.1971 4.9884 4.7932 4.6105 4.4392
13 12.1337 11.3484 10.6350 9.9856 9.3936 8.8527 8.3577 7.9038 7.4869 7.1034 6.7499 6.4235 6.1218 5.8424 5.5831 5.3423 5.1183 4.9095 4.7147 4.5327
14 13.0037 12.1062 11.2961 10.5631 9.8986 9.2950 8.7455 8.2442 7.7862 7.3667 6.9819 6.6282 6.3025 6.0021 5.7245 5.4675 5.2293 5.0081 4.8023 4.6106
15 13.8651 12.8493 11.9379 11.1184 10.3797 9.7122 9.1079 8.5595 8.0607 7.6061 7.1909 6.8109 6.4624 6.1422 5.8474 5.5755 5.3242 5.0916 4.8759 4.6755

16 14.7179 13.5777 12.5611 11.6523 10.8378 10.1059 9.4466 8.8514 8.3126 7.8237 7.3792 6.9740 6.6039 6.2651 5.9542 5.6685 5.4053 5.1624 4.9377 4.7296
17 15.5623 14.2919 13.1661 12.1657 11.2741 10.4773 9.7632 9.1216 8.5436 8.0216 7.5488 7.1196 6.7291 6.3729 6.0472 5.7487 5.4746 5.2223 4.9897 4.7746
18 16.3983 14.9920 13.7535 12.6593 11.6896 10.8276 10.0591 9.3719 8.7556 8.2014 7.7016 7.2497 6.8399 6.4674 6.1280 5.8178 5.5339 5.2732 5.0333 4.8122
19 17.2260 15.6785 14.3238 13.1339 12.0853 11.1581 10.3356 9.6036 8.9501 8.3649 7.8393 7.3658 6.9380 6.5504 6.1982 5.8775 5.5845 5.3162 5.0700 4.8435
20 18.0456 16.3514 14.8775 13.5903 12.4622 11.4699 10.5940 9.8181 9.1285 8.5136 7.9633 7.4694 7.0248 6.6231 6.2593 5.9288 5.6278 5.3527 5.1009 4.8696

25 22.0232 19.5235 17.4131 15.6221 14.0939 12.7834 11.6536 10.6748 9.8226 9.0770 8.4217 7.8431 7.3300 6.8729 6.4641 6.0971 5.7662 5.4669 5.1951 4.9476
30 25.8077 22.3965 19.6004 17.2920 15.3725 13.7648 12.4090 11.2578 10.2737 9.4269 8.6938 8.0552 7.4957 7.0027 6.5660 6.1772 5.8294 5.5168 5.2347 4.9789
40 32.8347 27.3555 23.1148 19.7928 17.1591 15.0463 13.3317 11.9246 10.7574 9.7791 8.9511 8.2438 7.6344 7.1050 6.6418 6.2335 5.8713 5.5482 5.2582 4.9966
50 39.1961 31.4236 25.7298 21.4822 18.2559 15.7619 13.8007 12.2335 10.9617 9.9148 9.0417 8.3045 7.6752 7.1327 6.6605 6.2463 5.8801 5.5541 5.2623 4.9995
60 44.9550 34.7609 27.6756 22.6235 18.9293 16.1614 14.0392 12.3766 11.0480 9.9672 9.0736 8.3240 7.6873 7.1401 6.6651 6.2402 5.8819 5.5553 5.2630 4.9999

n

i=1
=


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